In light of potential tax increases slated to go into effect in January (the "fiscal cliff"), many commentators are predicting that dividend stocks will crash. I've already analyzed why that argument is bogus in my article Do Dividend Stocks Pose Hidden Risks With The Fiscal Cliff Looming?
But the fiscal cliff isn't the only reason people are hating on dividend stocks. A Google search for "dividend stock bubble" reveals results from revered websites like Forbes, The Motley Fool, and our very own Seeking Alpha. Even my brokerage, Fidelity, is promoting an article called "Dividend Stocks: Time To Be Wary?" on the front page.
Let's examine some of the claims made by these articles and see if they add up.
1: Irrational Exuberance Means Dividend Stocks Are In A Bubble
According to the article from Fidelity, "Everyone is so crazy bullish on dividend-paying stocks these days, it's impossible to find a contrarian." This supposedly means that dividend stocks are at a market top and/or bubble and/or overvalued. The problem with this argument is threefold. First, "bubbles" typically occur in specific sectors (like real estate and tech) or for specific companies/classes of investments.
But arguing for a "dividend stock" bubble is essentially saying that one-third of the stock market is in a "bubble." According to a Fidelity screen, of the 6,577 common stocks in their database, 2,534 offer a dividend yield of >0.1%. This works out to around 38.5% of the market. Stating that 38.5% of the market is in a "bubble" is a little bit of a stretch, considering that US equities are undervalued from a historical perspective.
The second problem with the argument is that a "dividend stock bubble" would require dividend stocks to be priced at extreme levels in comparison to the broader market. This, too, does not add up. According to the Wall Street Journal, the forward P/E of the Russell 2000 is 14.67 and the forward P/E of the S&P 500 is 13. According to Seeking Alpha instablogger DividendSheet, the average forward P/E of the 15 most profitable Dividend Aristocrats was 15.04 as of June 19.
Therefore, sure, Dividend Aristocrats—the most highly regarded dividend stocks around—trade at a slight premium to the market as a whole. But you get what you pay for. Investors in companies like Exxon Mobil Corporation (NYSE:XOM), McDonald's Corporation (NYSE:MCD), Procter & Gamble Co. (NYSE:PG), and The Coca-Cola Company (NYSE:KO) are investing in high-quality brand-name companies that have a very strong history and a consistent focus on shareholder return. Am I willing to pay exorbitantly more for that? No. But a little bit more? Sure.
The third and final problem with the "irrational exuberance" argument is that it's an overgeneralization. Some individual dividend stocks may be overpriced, but that argument holds for ANY class of stocks—as we discussed above, dividend stocks are not hugely overpriced. Now, chasing pure yield and creating a portfolio 100% focused ONLY on maximizing dividends is asking for trouble: you can easily get 10%+ yields with mREITs like Annaly Capital Management, Inc. (NYSE:NLY), but such stocks are very volatile. However, I don't know of any investors who have constructed portfolios entirely of these stocks.
Most of the dividend investors I converse with here on Seeking Alpha focus on building a portfolio of quality "blue-chip" companies that they intend to hold for the long term. They know they'll get a slow but steady dividend that will increase by >5% annually over the long term. The reinvested dividends, plus the concomitant capital appreciation, will pay off handsomely in the long run. This isn't "irrational exuberance"—it's a strategy that should provide, at the very least, steady 7%-10% annual gains into perpetuity. Investors in dividend stocks generally aren't looking to hit a home run. They're looking for slow and steady appreciation of capital. That doesn't sound very bubbly to me.
2: Dividend Stocks Can Drop In A Downturn... Somehow Means Dividend Stocks Are In A Bubble
Wow. What a revelation. I had no idea that dividend stocks weren't immune from market downturns.
Now, "quality" stocks do tend to be pretty resilient in the face of downturns, as you can see from the chart below. (Please note, Exxon's stock has been impacted by secular trends in oil.)
Click to enlarge
Nonetheless, it would really surprise me if most dividend investors didn't know that like all other equities, dividend-paying stocks can drop in a downturn. But that doesn't mean investors by and large are running to "risky" dividend stocks. Huge inflows into Treasury bonds suggest otherwise—in fact, long-term Treasury bonds could be due for a collapse pretty soon. The fact that dividend stocks aren't immune from downturns doesn't mean they're in a bubble, it just means that investors should hold a diversified portfolio.
"Bubbles" are periods of irrational exuberance where the price of a certain asset skyrockets way above historical norms. Since dividend stocks are not priced irrationally, I am really not sure how any objective observer could conclude that dividend stocks are "in a bubble." It's important not to throw the proverbial baby out with the bathwater, while I am sure that some of the 2,534 dividend stocks out there might be overpriced, there are also quality stocks like Intel Corporation (NASDAQ:INTC) trading at a dirt cheap P/E of 11, which is hardly "a bubble." Thus, as always, investors should do their own research and thoroughly analyze the valuation of any stock before buying it.
If anyone has a different viewpoint, of course, I'd love to hear it. Please lay it out in the comments section below.