It is amazing how much market commentary is simply a discussion of the best and worst case scenarios. With fears over the European crisis still high, stocks volatile, and a press looking for sensational stories, it has become popular to consider only the most extreme scenarios.
One of the most hotly discussed topics in the market over the last several months is whether or not dividend stocks are in a bubble. With traders and investors seeking safe income and stable returns during volatile times, commentators are increasingly questioning if dividend and other income based investing strategies have become overcrowded.
I've written several articles about many leading dividend stocks, such as Altria (NYSE:MO), Procter & Gamble (NYSE:PG), AT&T (NYSE:T), and Kimberly-Clark (NYSE:KMB). While I think these companies are overvalued, I do not think these stocks are bubbles, and I think much of the framework of the discussion surrounding many of these companies is deeply flawed.
Dividend stocks have significantly outperformed the S&P 500 and its tracking exchange traded fund, SPY (NYSEARCA:SPY), over the last several years. With many leading dividend stocks at historically high price to earnings ratios despite having minimal long-term growth prospects, these companies do look overvalued. Still, finding reasonably priced value and growth is always difficult, and simply observing that a sector or company is trading above or below historic valuation levels does not require any particular insight.
While people often vehemently disagree over whether or not stocks or asset classes are in bubbles, the idea of a bubble is not overly complicated. Investments and asset classes usually form a bubble when the irrational exuberance of investors causes these individuals to no longer accurately appreciate the possibility of loss or limits on possible returns. Obvious examples of recent bubbles would be tech stocks in the late 1990s, and the recent housing market in the U.S. In both cases investors bought or invested with the idea that losses were next to impossible, since growth and price appreciation was seemingly inevitable. In both cases investors also had unrealistic expectations for likely short-term and long-term returns as well.
The term bubble is powerful, but this kind of terminology is also overused. This is why I think the idea that many fixed income investments and dividend stocks are in a bubble misses the point. Investing is always about the future, but the more uncertain the future is, the more important investing based on the present becomes. With the current economic outlook extremely volatile and rates likely to remain low for some time, determining what stage of the business cycle the economy is in has never been more difficult.
A company with an above average payout ratio will likely be valued at a slight to significant discount to a company reinvesting most of its profits within its business during an inflationary time. The reasoning is simple. If the purchasing power of currencies is falling and the value of assets is rising, reinvesting in assets and property will likely produce stronger long-term returns than simply paying dividends.
Likewise, when deflation is occurring and interest rates are low, companies paying dividends will be given a premium valuation since the value of assets and property will be declining while the dollar's purchasing power will likely be increasing.
However, the problem today is that both the economic and fiscal outlook are extremely uncertain. Nobody knows when rates will begin to rise, and this is exactly why discussing dividend and income investments as being in a bubble seems extreme at this time. It is impossible for an informed investor to say with confidence that income producing assets do not deserve a premium valuation without making impossible near-term inflation forecasts. Likewise, saying that fixed income assets such as treasuries are a bubble without making a credible argument that inflation and growth will accelerate significantly in the near-term is a poor argument as well.
The mistake that Bill Gross and many other fixed income investors are making when they say that the ten year treasury or dividend stocks are overvalued, is that these individuals are implicitly suggesting that inflation and growth will likely rise significantly in the near-term without sufficient evidence. Money obviously has a time value, and even if dividend stocks sell-off when rates rise in a couple years, investors receiving income today will still likely receive stronger returns than most fixed income investors for some time.
While most dividend and income based investments are overvalued, these investments are historically overvalued because we are in historically unique times. This is not a this time is different argument, it is a simple observation that as long as rates are low and deflation continues, investments offering stabile income returns more than 3% above the prime rate will continue to be given a premium valuation.
The valuation of a company able to offer income of 3% or more than what most fixed income investments offer will likely continue to be valued at historically high levels as long as the company continues to maintain or increase its payouts, and inflation remains low. For an individual to credibly say that these income based investments are in a bubble implicitly suggests that the person has a crystal ball showing that inflation will accelerate significantly within the next six months to a year.
To conclude, I continue to believe that most leading dividend stocks are moderately to significantly overvalued, and cyclical companies will likely offer the best income and total returns longer-term. Still, if traders or investors are simply investing for stable income, dividend stocks and other income based investing strategies are likely to continue to work. Growth and inflation will likely accelerate at some point, but the future remains highly uncertain, and these stocks won't collapse overnight. While the mid-double digit price to earnings ratios most leading dividend stocks with minimal growth are trading at is not sustainable longer-term, there is little evidence that rates and inflation will rise significantly in the near-term.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.