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Dividend Bubble?

By Morgan Housel - Updated Apr 7, 2017 at 7:37PM

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It's never smart to bet on what's popular. Dividend stocks are no exception.

Have you ever been excited about Consolidated Edison (NYSE: ED)?

Probably not. But its shares returned 50% in the last two years, double the rate of the broader market --not bad for a regulated utility. ConEd's dividend yield, an inverse reading of its valuation, is now the lowest since the 1990s.

Altria (NYSE: MO) has suffered a string of dismal earnings reports as smoking rates decline. Just don't tell the market: Its shares are also up nearly 50% in the last two years and now trade at the highest valuation since 1998.

What's unique about Edison and Altria? They pay enormous dividends. And starved of yield with interest rates near 0%, investors are tripping over themselves to get dividends these days. S&P 500 companies with the highest dividend payouts currently have the highest P/E ratios. In 2007, it was the other way around: Stocks that didn't pay dividends had far higher valuations.

But don't get too comfortable with the dominance of dividends. There's a bad precedent here. Last decade, the Federal Reserve kept interest rates far too low for far too long. Starved of income from Treasuries, investors were tempted to search for yield wherever they could find it, which back then meant subprime mortgage bonds. You know how that went.

Blue-chip dividend stocks are not subprime bonds. But there's an argument to make that, just as investors ran blindly into subprime bonds five years ago in search of yield, they're running blindly, carelessly into dividend stocks today.

The tables may already be turning. So far this year, S&P 500 stocks that don't pay dividends are up 8.3%, while those that do are up just 1.3%. That makes sense: As it becomes clearer that the economy is recovering, investors are more keen to take risks rather than hiding in the warm embrace of dividend stocks. Last year, it was flipped: Dividend stocks handily outperformed the nonpayers as it looked like a new recession was imminent.

It all comes down to valuations. And the more I look, the more it becomes apparent that stocks known for their dividends trade at unfortunate valuations that could leave investors disappointed. I already mentioned Edison and Altria. Most utility companies have also seen phenomenal returns and now trade at historically high valuations. McDonald's (NYSE: MCD), a favorite of dividend investors, now trades at a brisk 19 times earnings after doubling in price in two and half years. Caterpillar (NYSE: CAT), another dividend dynamo, has seen its dividend approach the lowest yield in a decade after shares doubled since 2010.

These are high-quality companies that deserve premium multiples. And there are exceptions to the rule. But for the most part, dividend-paying stocks are some of the most expensive and sought-after stocks in the market. Going forward, investors might get what they pay for (don't they always?).

There may be, in other words, a dividend bubble.

I'm aware of how bad most people, including (sometimes especially) myself, are at predicting market trends. I may be wrong here, and there are two reasons why.

First, the Federal Reserve just signaled plans to keep short-term interest rates near 0% until 2014. That could keep demand for dividend-paying stocks high for years, as they provide some of the only yield left in the entire investment universe.

Second, the dividend payout ratio on S&P stocks is near an all-time low. S&P 500 companies could more than double their dividends without breaking any historical precedent. Howard Silverblatt, S&P's chief number cruncher, expects dividends to rise 11% this year. "The dividend story is good and should continue to be good," he said recently. He may very well be right.

But dividends are sensationally popular right now, and rarely does it pay to follow the crowd. Buying high-dividend stocks three years ago was clearly a wise bet. Whether it will be wise over the coming three years is another story.

Don't buy it? Still bullish? If you're still in the market for some really high-quality dividend stocks we think will perform well over the long run, check out the Motley Fool's free report, "Secure Your Future With 11 Rock-Solid Dividend Stocks." It's free. Just click here.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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Stocks Mentioned

Altria Group, Inc. Stock Quote
Altria Group, Inc.
$43.48 (-0.59%) $0.26
McDonald's Corporation Stock Quote
McDonald's Corporation
$250.30 (0.12%) $0.29
Caterpillar Inc. Stock Quote
Caterpillar Inc.
$195.92 (-1.41%) $-2.81
Consolidated Edison, Inc. Stock Quote
Consolidated Edison, Inc.
$80.35 (2.14%) $1.68

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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