MONEY income investing

Dividend Stocks Look Tempting. You Should Resist

The unexpected drop in interest rates this year has investors scrambling for yield again. This has given a lift to REITs, utility stocks and other dividend payers.

The market’s love affair with income-producing stocks is back.

For years, investors frustrated by record-low interest rates in bonds turned to equities to satisfy their need for income. That was a boon to shares of high-dividend-paying stocks, such as those found in the utility and telecommunications sectors. It also helped power gains for real estate investment trusts (REITs), which manage commercial real estate properties and throw off tons of income.

That was until the middle of last year, when these high-yielding investments began to get frothy and rising interest rates drove income investors back into bonds. As the chart below shows, utilities and REITs fell back to earth at that point, even as blue chips finished out a banner year.

^SPX Chart

^SPX data by YCharts

So far this year, though, circumstances have changed once again and the dividend payers are back.

Why? Despite widespread expectations of rising rates, yields on 10-year Treasury notes have actually taken an unexpected downward turn this year. Chalk it up to a variety of factors: slower-than-expected global growth, the perception (right or wrong) that inflation isn’t a problem, and geo-political concerns stemming from Russia’s threats against Ukraine earlier in the year.

10 Year Treasury Rate Chart

10 Year Treasury Rate data by YCharts

Not surprisingly, conservative investors have renewed their search for alternative sources of income. Hence, the outperformance of stocks in traditional dividend-payers and REITs.

^DJER Chart

^DJER data by YCharts

But just because the market’s interest-rate forecasts haven’t panned out — at least not yet — that doesn’t mean the other problems that weighed on income-producing stocks last year have gone away.

Namely, these stocks remain expensive. The average utilities stock trades at a price/earnings ratio of about 20, versus around 16 for the S&P 500. Historically, the sector has traded at a discount, not premium, to the broad market.

The higher the yield of a stock, in fact, the worse its valuation picture is likely to look. Sam Stovall, managing director for U.S. equity strategy at S&P Capital IQ, found that shares of S&P 500 companies yielding 2.5% or more traded at a 20% premium to blue-chip stocks yielding between 1.5% and 2.5%.

He recommends that you not “yield to temptation by stretching for income and turning a blind eye to valuations and volatility.” He adds: “Don’t chase yield for yield’s sake, but incorporate other fundamental valuation parameters into your search.”

One alternative technique that has historically paid off is to focus on companies that are growing their payouts rather than going after the absolute highest yielders. Historically, the average stock that consistently raises its dividends has returned 10.4% a year, according to Ned Davis Research. By comparison, dividend payers that don’t boost their payouts returned a full percentage point less per year.

A cheap and easy way to gain exposure to dividend growers is through the SPDR S&P Dividend ETF SPDR SERIES TRUST DIVIDEND ETF SDY 0.3907% . The index fund only includes stocks that have raised their dividends every year for at least 20 straight years.

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