Strong Signs Dividend Stocks Are Approaching Bubble Territory

Includes: COST, CVX, GE, KMB, MO, SPY, WMT
by: The Independent Investor

Wow, the market has been brutal of late. While the S&P 500 and its tracking exchange traded fund, SPY, is down around 10% in the last month, sectors such as energy and the financial sector have fallen over 20%. Even leading technology stocks such as Microsoft (NASDAQ:MSFT) and AAPL are off around 15% from the highs these stocks made earlier in the year.

Still, it is interesting how well the broader indexes have held up while leading companies such as Citigroup (NYSE:C), JP Morgan (NYSE:JPM), Caterpillar (NYSE:CAT), and GE, have sold-off 20% or more. The one sector that has held up very well has been consumer staple stocks. Specifically, companies with less cyclical business models yielding nearly 2.5% or more, such as Wal-Mart (NYSE:WMT), Costco (NASDAQ:COST), Altria (NYSE:MO), and Kimberly-Clark (NYSE:KMB), are all at or near these stocks three year highs. Unsurprisingly, many mutual funds leveraged to high yielders, and exchange traded funds leveraged to dividend stocks, have also performed very well even during the recent sell-off.

Today the 10 year Treasury yields less than 1.5%; many leading cyclical stocks in sectors such as financials and industrials have sold-off over 20%, and fear and pessimism levels are rising. Oil has fallen nearly 30% in three months, European stocks are trading at levels not seen since the summer collapse of last year, and the dollar continues to rise against most major currencies.

I have been a firm advocate of dividend stocks for several years, first advocating investing in Lorillard (NYSE:LO) when the stock was in the seventies when I wrote my first article for Seeking Alpha nearly a year ago, and recommending investing in the tobacco sector as recently as February of this year. Still, there are a couple warning signs that dividend stocks are likely now moderately to significantly overvalued.

The first sign dividend stocks are likely overvalued is that many of the leading dividend stocks in mutual funds and exchange traded fund have sold-off very little during the recent sell-off. While some cyclical stocks in the industrial and financial sectors have sold-off over 20%, the S&P 500 is down around 10%, and many leading consumer staple and dividend stocks such as Kimberly-Clark and Wal-Mart are less than 1% of these stocks 3 year highs. Essentially, since obviously cash and fixed income offer basically no returns today, wealth managers seem to have simply sold cyclical stocks and bought high yielders during the recent sell-off rather than raising cash during the sell-off last year when fears of a recession were much higher.

Buying high yielding stocks with countercyclical business models during a period of market weakness is obviously a logical decision. Still, if everybody has the same trade on, it's easy for a sector or group of stocks to get overvalued. The fact that many of these leading dividend and consumer staple stocks are less than 1% from these companies' all-time highs suggests investors have grown complacent about the consistency of the returns this sector can offer. It also suggests that many investors are likely putting money into dividend paying stocks as a safe haven play, not a long-term investment.

The second reason dividend stocks are likely overvalued at this level is that these stocks are not realistically pricing in possibility of inflation. While countercyclical business models are great during periods of deflation, its unrealistic to think the Fed and Central Banks and governments around the world will not continue to do nothing if economic growth continues to slow. While the short-term and long-term effects of stimulus and growth will always be hotly debated, you very rarely can have massive stimulus and no inflation. With growth prospects dim and the TIPS market now pricing in 0 inflation for the next year, many investors in companies such as Wal-Mart and Costco, companies with dividends less than 2.5%, trading at 18-20x earnings despite long-term growth prospects likely in the single digits, could be hit hard if inflation expectations rise even modestly.

The third reason that many leading dividend stocks are likely overvalued is that bullish sentiment towards dividend stocks is reaching the highest levels in decades. While sentiment is always hard to gauge, I thought it was especially interesting that for the first time since Vanguard introduced the first exchange traded fund in 2000, we are now seeing leveraged divided funds. While many leveraged exchange traded funds are great trading tools levering up at 2-1 in a sector that is supposed to offer conservative but stable returns seem to suggest bullish sentiment towards dividend investing is peaking. Articles and commentary on dividend stocks are also dominating many financial news sites.

To conclude, while the fundamentals of many leading dividend stocks, such as Altria and Costco, are strong, these stocks are less than 2-3% off these companies' all-time highs, while many cyclical stocks paying 4-5% dividends, such as GE and Chevron (NYSE:CVX), are off over 15% in the last several months. With the TIPS market pricing in 0 inflation over the next year, the ten year treasury yielding less than 1.5%, and major leadership changes and elections occurring in the U.S. and China this year, it still seems likely that new stimulus measures will be enacted if the growth outlook continues to weaken. While cyclical companies with steady growth yielding 3-4% will likely benefit from growth or inflation, even a modest increase in inflation expectations could significantly hurt the expected returns of many consumer staple companies.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.