As investors have reached for yield, dividend stocks have hit extremely high valuation levels, says Faber. As a stock’s value rises, its dividend yield must decrease—as a result, the cost of creating dividend-paying strategies increases as their popularity rises.
In 2016, the valuations of both dividend-growth and high-yield dividend stocks reached their highest levels in years. Perhaps as a result, dividend indexes lagged their benchmarks in 2017.
“If everybody does the same thing, strategies begin to suffer,” says Scott Colyer, CEO at Advisors Asset Management. “As soon as an anomaly is discovered by investors, returns begin to decline over time.”
Indeed, recent research from the University of Chicago found that the outperformance of dividend stocks disappears as they become more highly valued—investors initiating a dividend strategy today may lag inexpensive and efficient benchmark indexes throughout their investment experience.
Today’s dividend-paying equity universe struggles to beat the common 4% withdrawal rule of thumb used to inform many financial plans. Most high-yield and dividend growth indices offer yields of 3% or less. If the trend continues, it may not be possible to create a retirement income strategy using dividends alone—some amount of share harvesting will have to occur.
Some dividend stocks may also be in a bubble, with valuations breaking beyond the bounds of reason. As the bubble deflates or bursts, valuations revert toward the market average and dividend stock prices fall, and then investors might not find willing buyers for some of their dividend investments.
“Why would I invest in a dividend strategy when the composite valuation measures are much higher than the U.S. stock market in total?” asks Faber. “If dividends have outperformed because they give investors a bit of a value exposure, we shouldn’t expect them to outperform now that they’re no longer concentrated in low-valuation stocks. Their returns should be muted moving forward.”
Disruption
Dividends don’t last forever.
A sudden shift in the economy can make a stalwart blue-chip dividend grower unprofitable. Too much debt can compress a company’s ability to afford its dividend payment. And as its management changes, a company’s cultural commitment to maintaining its dividend may also change.