It's hard to earn a meaningful rate of return these days due to the low interest rate policy of the U.S. Federal Reserve. This has been the case for years as the central bank has tried to stimulate the U.S. economy and push investors into risk assets. This strategy has clearly worked. However,, just as government policies of low down payment mortgages created a bubble in the housing market, it appears to be creating a bubble in certain dividend-paying stocks.
In particular, the telecom sector has seen a tremendous rise since the 2008 financial crisis and that could mean future returns might be limited, or even negative if valuations revert towards the mean. A recent Barron's article sums up the massive expansion in the price to earnings multiple of telecom sector stocks over the past few years, it states:
When this bull run began in March 2009, telecom stocks fetched just 9.2 times what phone companies had earned over the preceding 12 months, according to data from Bespoke Investment Group. By last week, that had jumped to 23 times -- the biggest increase of any sector excluding financials, and a sign that telecom stocks are rising much faster than their earnings.
For many investors, stocks like Verizon (VZ) and AT&T (T) have been ideal investments that have provided higher than average dividend yields, and a rising stock price. However, as the saying goes, "past performance does not indicate future results". If telecom sector stocks were to revert back to a PE ratio of about 9.2 times earnings, from a current 23 times earnings, that could lead to a drop of about 50% in the share price. A drop of that size seems improbable since interest rates are likely to remain low, plus the sector is benefiting from growth in mobile devices. However, it does seem possible the uptrend in this sector has run its course and it could be due for a significant pullback of at least 10 to 15%. Based on historical valuations, investors should consider taking profits and waiting for better buying opportunities which are likely to come in the future.
Since both AT&T and Verizon shares have been performing well and now trade near 52-week highs, it could make sense to take profits and wait for a pullback. While it can be tough to sell a stock that has performed well, this is part of the strategy of "buy low and sell high". Selling into strength and when historical valuations are near record levels, could payoff for current investors.
Key Data Points For AT&T From Yahoo Finance:
Current Share Price: $35.32
52-Week Range: $27.41 to $38.58
Dividend: $1.76 which yields 4.9%
2012 Earnings Estimate: $2.38 per share
2013 Earnings Estimate: $2.59 per share
Key Data Points For Verizon From Yahoo Finance:
Current Share Price: $45.16
52-Week Range: $35.32 to $48.77
Dividend: $2.06 which yields 4.5%
2012 Earnings Estimate: $2.47 per share
2013 Earnings Estimate: $2.83 per share
Data is sourced from Yahoo Finance. No guarantees or representations are made. Please consult a financial advisor before making investments.
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.