Dividend stocks have been thriving in the low interest rate environment. Dividend-paying stocks, which we define as stocks with higher dividend yields than the broad equity market, have garnered support as investors increasingly use stock dividends as a substitute for fixed income in the low interest rate environment. But has the market’s thirst for yield gone too far? Are these stocks in a bubble? This week we take a look at high-dividend-paying stocks to assess whether these stocks are in a bubble and if investors should actually view high dividend yields as a warning sign.

DIVIDEND MANIA

There are a number of reasons for the increased popularity of high-dividend-paying stocks. First, bond yields are near record lows due to central bank stimulus worldwide and low inflation, leading investors to increasingly favor higher yields offered by equities over bonds — despite the higher volatility that comes with that swap. In fact, the percentage of S&P 500 stocks with dividend yields higher than the 10-year Treasury yield is over 60%, which is the highest it’s been since at least 1970 [Figure 1]. No wonder more investors are turning to equities for yield.



Friday’s slightly weaker than expected jobs report (released on September 2, 2016) will potentially add to the enthusiasm for dividend-paying stocks, as the report may take a September 2016 Federal Reserve (Fed) rate hike off the table (we still expect a Fed rate hike in December after a largely election-related pause at the Fed meeting in early November).

Stocks that pay dividends have also performed better over the long term. Figure 2 separates stocks by dividend policy and shows that stocks that have paid dividends have returned 9.1% annualized since 1972, compared with just 2.5% annualized for non-dividend-paying stocks. Though more scarce, companies that have initiated or grown their dividends have historically performed best, with a 9.9% annualized return over this long period. Companies know that investors like dividends and they deliver them as much as they possibly can.

ARE DIVIDEND PAYERS EXPENSIVE?

Have investors become overly excited about dividend payouts? Perhaps. Figure 3 shows the median price-to-earnings ratio (PE) of high-dividend-paying stocks, at just over 19, has risen well above its more than 40-year average of just over 12.5 (that’s nearly two standard deviations, which is a pretty big margin). That’s expensive. But when comparing the PEs of high-yielding stocks against the broad market, they do not look so expensive—the median PE of the S&P 500 is 24, also well above its long-term average near 16. (Note that because median calculations are not dominated by mega caps, median valuations provide a broader picture of stock valuations than market cap weighted valuation measures, although we believe both valuation measures have merit.)



We have written repeatedly that we believe the equity market is slightly expensive. We have also noted that the popular dividend-paying sector, utilities, is richly valued at a premium to the S&P 500 on a market cap weighted PE basis (11% premium to the S&P 500 as of September 2, 2016). So although we would agree that the market’s thirst for yield has pushed valuations of high-dividend-paying stocks above fair value, it is hard to make the case that they are much more expensive than the stock market as a whole; thus, we do not think these stocks are in a bubble.

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