Written by Ben Carlson
US dividend stocks have had a great run. They outperformed during the 2000-2002 bear market. They held their own in the ensuing bull market of 2003-2007. They have also made great investments since the 2008 downturn and subsequent recovery.
Since 2008, as measured by the SPDR S&P Dividend ETF (SDY), US dividend stocks are outperforming the S&P 500 by nearly 25% through the end of October.
This is quite a nice run for an investment that is generally considered to be stable and long-term in nature. Dividend stocks have also outperformed with much lower volatility than the rest of the market, which means that they have fluctuated in price much less than the overall market. As you can imagine, investors are much more comfortable investing in stocks that don’t exhibit wilds swings in price.
Studies have been coming out for the past few years showing the superiority of low volatility investment strategies, and investors have taken notice. Most of these low volatility stocks tend to be steady dividend paying companies, so they have been the beneficiary of continued investment by those looking to get in on this theme.
Investment 101 teaches that to earn a higher return on an asset you must take higher risk. Having low volatility stocks outperform high volatility stocks is therefore an anomaly that has caught the attention of the investing public.
Unfortunately, any time investors learn about an anomaly such as this they tend to pile into that investment theme and things can become overheated. You can also get investors involved that aren’t in it for the long haul.
I think that’s what has happened to US dividend paying stocks lately. Here’s a table with various valuation metrics to show how things have changed in the past five years:
You can see that price to earnings, price to cash flow, and price to book valuations have all been rising steadily. At the same time, the dividend yield has come down quite a bit from 2009. Obviously, any time a market has such a swift rise in price the valuation metrics are also going to rise.
But dividend stocks have historically tended to trade at or below market valuations. They have been steady cash flow generators with lower growth prospects than other segments of the market. This doesn’t seem to be the case right now.
The S&P 500 currently trades at a P/E multiple of 16.7 with a dividend yield of around 1.9%. So there’s still a higher yield in dividend stocks over the broader market. At the moment however, you’re paying a premium for that yield.
I’m not saying the US dividend stocks are setting up for a crash. I can’t predict the future. But it would be logical to conclude, that the higher performance against the broader market for US dividend paying stocks, could be lower going forward for a few years. Investing in US dividend paying stocks at higher valuations, and lower dividend yields, could lead to future disappointment for investors in these stocks.