What’s Going On With Dividend Stocks?

May 24, 2018

What’s Going On With Dividend Stocks?

  • Dividend investments have been loosing ground lately.
  • If the FED raises rates 4 times in 2018, there will be more ground lost.
  • However, there is a dividend strategy that will do well no matter what happens.



Introduction

One of the most loved investing strategies is dividend investing.

Dividends are something that we can see giving us a reward at least once a year and are a much more sure thing than many other possible investment returns. However, lately dividend investors haven’t been having a great time as, while dividend years have been going up, asset prices have been going down, especially for many of the most beloved dividend stocks.

Today, we’ll discuss what’s going on and how to approach the situation if you are a dividend investor. We’ll start with an overview, take a look at the most probable scenario, and conclude with putting the current dividend investment scenario in an historical perspective.

Dividend Investing Overview

Now, I’m a firm believer that the market is irrational which means that more often than not, it offers investors better risk reward opportunities than what the market average is. However, the case with dividend stocks is a bit different.

Let’s discuss the iShares Core High Dividend ETF (HDV) which has Exxon (NYSE: XOM), AT&T (NYSE: T), Verizon (NYSE: VZ), Chevron (NYSE: CVX) and Johnson & Johnson (JNJ) in top position with a combined weight of 34%. The fund is well diversified, a bit overweigh energy, but that is exactly where the largest dividends are.

Figure 1: HDV’s sector exposure. Source: iShares.

The management fee is practically nothing at 0.08% and the dividend yield is 3.62% which is much higher than the S&P 500 dividend yield of 1.84%.

Now, the performance of the HDV ETF has been nothing short of stellar since inception, and $50 invested in 2011 would now be at $85 not counting the yield over time.

Figure 2: HDV’s performance since inception. Source: iShares.



However, the situation hasn’t been that positive over the last 6 months, and the ETF is down almost 10%.

Figure 3: HDV is down 10% from its peak in January 2018. Source: iShares.

Now, what all dividend investors would like to know is whether the ETF can fall another 10% in the next 6 months and what the triggers could be.

The main trigger for the decline in dividend-related funds are interest rates.

Dividend funds are loved for their stability and certainty. However, there is something more stable and safer than dividend ETFs, Treasuries. In the last 6 months, the yield of the 10-year U.S. Treasury has gone from 2.3% to 3.06% today.

Figure 4: U.S. 10-year Treasury yield. Source: FRED.

The conclusion is that on one hand, you have stocks with a dividend yield of 3.6% and we all know stocks are risky and no one can guarantee you anything. Just look at what has been going on with General Electric (NYSE: GE) over the past year.

Figure 5: GE’s stock price in the last year. Source: CNN Money.



A dividend of 3.8% is great, but if you lose another 10% in the next 6 months, you need 3 years for the dividend to cover the loss. So, if the FED continues to raise rates, the yield on the safe haven Treasuries will also increase and, consequently, investors will require a higher yield from dividend investments.

If the required dividend yield goes to 5%, you can expect the HDV ETF to decline to a price of $61.2 if the current dividend holds. A decline of $24 implies 8 years of dividends, which is a lot to risk for a premium of just 55 basis points (0.55 of a percentage point) above the 10-year Treasury.

The FED’s meeting minutes released on Wednesday show how there is a possibility for 4 rate hikes this year. The current rate is at 1.75% which means that we could see 2.5% by the end of the year and, consequently, the 10-year Treasury at around 3.75%.

Figure 6: Effective Federal Funds rate and the 10-year Treasury over the past two years. Source: FRED.

If the 10-year Treasury hits 3.75%, I wouldn’t be surprised to see the HDV dividend ETF hit 5%, and thus fall to $61 as identified above. An important point to note here is that the FED is contemplating raising interest rates above their expected normal rate of around 3% in order to prevent the economy from growing at a faster than sustainable rate. This could further impact dividend related investments.

Dividends & Earnings

I’m not a dividend investor because I know that earnings are the core behind investment returns. If earnings are distributed as dividends or reinvested, there’s not that much of a difference except for the taxes paid on dividends. So, I personally prefer an earnings yield of 4% where the dividend is just 2% rather than an earnings yield of 3% and a 3% dividend yield.

The problem with stocks focusing on dividends is that often their payout ratios are above 100%, which doesn’t leave much room for growth without debt and with interest rates rising, that debt costs more.

Dividend or no dividend, your long term investing return will be determined by the earnings yield and not by the dividend yield even if in the last 100 years most of the investment returns investors achieved were thanks to dividends, but the world has changed a lot as the average dividend yield was much higher then and so was the average earnings yield.

The average dividend yield for the S&P 500 since 1871 was 4.3% while the average earnings yield was 7.38%. Given that the current dividend yield is 1.8% and the earrings yield is 4.03%, history tells us that both investing in dividends and stocks is risky and that if you want yield and safety, you might really want to look at those Treasuries that guarantee you your principal and have a yield between 2 and 3%.



The Ultimate Dividend Investor

The ultimate dividend investor is one who is happy when prices fall as they can reinvest and buy more of the same.

If that is your strategy and your investing horizon is pretty long, you’ll like the dividend reinvesting strategy and you should keep adding to your portfolio in the form of dollar cost averaging. A dividend investing strategy will give you good returns over the long term, no doubt about it.

However, the key here isn’t so much the yield, but your discipline in doing the same even when things go bad, which will happen and in such a scenario, a small starting capital at this point in time also helps.

Dividend Income Investors

Dividend income investors might really think about Treasuries as risking what you have and need for something that you don’t need isn’t wise at all.

Conclusion

Consider what you need in life, what your goals are, and whether the risk reward of the instruments you hold will lead you to where you want to go.