Alpha Power Investing Newsletter

April 28, 2011

The Dividend Trap

As you might expect, I get a lot of trade publications. Recently, I've been noticing quite a few articles and advertisements recommending that yield-starved investors should shift from bonds to dividend-paying stocks.

The pitch makes a couple of dubious claims. For one, there's the suggestion that high dividends and dividend growth will help cushion these stocks from market declines. Another claim is that, unlike bonds, stocks have historically protected capital during periods of rising interest rates and inflation.

Both of these claims are false and misleading.

Let's start off with the good news. It's true that across the entire market, historically, dividends have increased at about 6% annually. This is pretty much in line with the historical growth of earnings. It's also true that if you invest in a good, steady dividend-paying stock at the right price, you've got three factors working for you: an appreciating stock, a fat yield, and increasing yield over time.

Now, let's sort out the negatives.

While dividend-paying stocks are viewed as more stable and higher quality than non-dividend stocks, this can lead to what is known as "the dividend trap". Stocks which pay dividends considerably higher than average are most often riskier than average. The higher dividend is a signal that investors require more income to compensate for the lower earnings quality of the company.

In 2008-09, this fact was demonstrated in the performance of many funds and EFT's which claimed to be "dividend oriented". Here is the inflation-adjusted total return for a few of them.

As you can see, the PowerShares High Yield Dividend EFT has been a disaster, chiefly due to the fact that the portfolio is weighted by yield, giving the highest yielding stocks the greatest weight. As a result, the portfolio was over-weighted in financial stocks during the banking/insurance meltdown. The best performing fund was the Vanguard Dividend Growth Fund, but its superior performance had nothing to do with yield. The yield on the fund is the same as the S&P 500. The fund is over-weighted with companies that have wide business moats - firms with strong brands that guarantee steady, repeat sales.

None of these funds did a great job of "cushioning" the last bear market. The returns in the chart are with dividends reinvested. Had investors used these dividends as a source of income over the past five years, their wealth would have been seriously eroded by the best of them, and destroyed by the worst.

Currently, the S&P 500 yields 1.75%. The chart below shows how far removed this yield is from the historical average.

If you buy "yield" today, you are betting that "yield" five or ten years down the road will be about the same. If it isn't - if it is considerably higher - it will reflect the fact that stocks have declined in price over the interim, rendering the strategy null and void.

Part of the pitch for dividend-paying stocks is that the stock market provides protection from inflation. This claim is just not true. The chart below shows the inflation-adjusted price of the S&P 500 for the past 130 years.

Over this period, there have been two great inflations: 1912-1921 and 1968-1981. The inflation of World War I resulted in a real price decline of 70%. The inflation of the 1970's produced a real decline of 60%. Rising inflation drives investors into short-term fixed income instruments, which continuously adjust to rising interest rates. While corporate earnings may rise during inflationary periods, investors don't know how to value the growth and tend to bid stocks down to dirt cheap levels. Recovery times can be long. The S&P 500 did not exceed its 1968 inflation-adjusted price until 1991.

At the outset, I said that investing in good, steady dividend-paying stocks is a great investment at the right price. For almost all stocks, this is a market issue, not an individual stock issue. If the market is expensive and risky, almost all stocks individually are too. The question becomes, then, is the market cheap? Are investors provided with a margin of safety which increases the odds of success to the level where long-term continuous exposure to market risk is justified?

A look at our final chart answers that question definitively, as far as I'm concerned.

The chart shows the 130 year history of the S&P 500's valuation levels. A high valuation (PE Ratio) translates into a low probability for robust returns in the future. Please note that rising and falling PE ratios are perfectly correlated with a rising and falling stock market. The poorest long-term investment climates are those associated with a PE above 20. With the current PE at 23.6, we are in one of those periods where the odds of a long-term rise in stock prices are extremely low. Buying stocks today to hold for the next five to ten years, whether dividend-paying or not, requires investors to believe that the market will lift to heights of valuation comparable to the go-go years of the late 1990's. Not likely.

The best course of action is to view the market opportunistically as a temporary investment vehicle.

We are now in the pre-election year - a year that has been up every time since 1931 (Dow Industrials, total return). This positive investment climate should extend into the election year. Investors should keep in mind that the growing earnings and high profit margins that U.S. corporations now enjoy are mean-reverting and cyclical. If inflation above the normal 2% - 3% enters the picture, this positive phase will eventually give way to a substantial decline. The most dangerous period historically has been the first and second year of the presidential election cycle.

In conclusion, the attraction of dividend income at this moment in history must be weighed against the odds of capital depreciation from inflation, rising interest rates, and lower market valuations in the future. My take on it is simple: this is just about the worst environment I can think of for a long-term commitment to dividend investments.

If you would like to discuss any of our investment programs, please call me at 1-877-229-9400.

Jerry Minton, Ph.D.
1-877-229-9400, Ext. 11

Past performance is not a guarantee of future performance.

© 2011 Alpha Investment Management Inc.

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