Are Dividend Stocks Dead?

The U.S. stock market has been a well-oiled money-making machine for decades. Its short-term impulses can be frustrating but tend to be smoothed out over the long term. Those with the patience to tolerate the volatility have turned routine savings into generational wealth.

A key attribute of many great stocks is an attractive dividend, which provides scheduled income no matter what the stock price is doing. But the market's surge has shrunk the dividend yield of the average stock in the S&P 500 to just 1.3%, the lowest level in nearly 20 years. Such a small return reduces the feasibility of supplementing income with dividends -- which used to be a go-to strategy recommended by financial planners. This is especially problematic for retirees who depend on dividend income.

Let's address the elephant in the room -- are dividend stocks dead? And if so, what should investors do about it?

Image source: Getty Images.

A double-edged sword

Shrinking dividend yields aren't a problem for investors who have a substantial amount of their savings already invested in the stock market. Their capital gains are likely to eclipse any shortfalls in dividend income. However, for those who are new to the stock market -- or for existing investors looking to shift from an asset accumulation to distribution phase -- high stock prices and low dividend yields provide less upside.

SPY Dividend Yield data by YCharts

When stock prices rise faster than a company can grow its earnings, then the price-to-earnings (P/E) ratio will increase. The issue is that many excellent companies now have much higher P/E ratios than their historic averages. It doesn't mean the company is better or worse. It just means that the market is willing to pay more for stocks than it used to due to a belief that earnings and revenue will grow well into the future. Put another way, there's a lot of optimism in the stock market right now.

The trade-off between growth and income

The reality is that the stock prices of many once-excellent dividend stocks have risen faster than companies can increase their payouts.

AAPL Dividend Yield data by YCharts

In the not-so-distant past, the stocks of well-known companies like Apple, Microsoft, Walmart, and Starbucks all had a dividend yield above 2% or even 3%. Now, both big tech names yield less than 1%. And Starbucks and Walmart yield around 1.6%.

In many ways, the age of tech giants that pay handsome dividends is dead. Similarly, it's getting harder to find stocks that offer both growth and income. The following chart provides a summary of the trade-offs between growth, income, and value -- using a few sectors as examples. The information in the table doesn't apply to every technology, industrial, and consumer staple stock, but rather, is meant to illustrate characteristics that are generally associated with these sectors.

Generally speaking, there's an inverse relationship between growth and income. Bull markets add an additional wrinkle to this relationship by eroding the dividend yields of all stocks. The result is that investors who want a dividend yield above 2% or 3% have to go further and further away from growth toward value -- a compromise that may not suit the financial goals of many.

What to do about it

Instead of chasing high dividend yields, investors are better off finding quality businesses with a track record for raising their payouts. A good place to start is by looking at the list of Dividend Aristocrats. Dividend Aristocrats are members of the S&P 500 that have raised their annual payouts for at least 25 consecutive years.

You'll find a variety of companies from different industries. A few that come to mind are consumer staple titan Procter & Gamble (PG 0.54%) and industrial behemoth Caterpillar (CAT -0.55%). The consumer staple sector can be an excellent place to find reasonably valued, high-income, super-safe dividend stocks. Companies like P&G tend to have mid-single-digit organic growth rates. Despite this slow growth, demand for P&G's products is fairly consistent whether or not the economy is doing well, which makes the stock relatively recession-proof.

Caterpillar is a cyclical stock. Its earnings will ebb and flow as the economy expands and contracts. But over the long term, it has proven it has the cash to keep increasing its dividend and grow its business. Caterpillar yielded 3% and even above 4% not too long ago when its stock price was lower. However, the company is on the cusp of entering what could be a multi-year growth cycle. Given its growth prospects and 2.1% dividend yield, Caterpillar could be a good dividend stock to buy now.

Find what's best for you

Investors can surf the growth and income spectrum to find the balance that's best for them. Buying stocks when the market is at an all-time high can seem like a counterintuitive proposition. It's worth remembering that far more money has been left on the table waiting for a market pullback than buying too high. One of the secrets to outperforming the S&P 500 is acknowledging the psychological battle of investing. Balancing the trade-off between growth and income in a way that lets you sleep at night is likely to be a winning strategy over the long run.