Why It's Time to Dump Your Dividend Stocks

General Electric
General Electric

With 10-year U.S. Treasury bills paying less than 2%, there's a lot to be said in favor of owning dividend stocks rather than bonds these days.

The Dow Jones Industrial Average's (^DJI) surge to 13,000 (and beyond) means that fans of capital gains are also sitting pretty. And according to a recent poll of financial experts conducted by Barron's, dividend-paying stocks are the place to be, because they offer the best of both worlds -- a dividend payment today and a higher stock price tomorrow.

In the magazine's annual report on the "top 1,000 financial advisors," recommendations to buy shares of generous dividend payers such as General Electric (GE), Merck (MRK), and AT&T (T) featured prominently. As one member of Barron's illustrious 1,000 boasted: "Ninety-five percent of everything we buy pays us in some form of dividends or interest." And it seems investors are in no hurry to change that.

Why not? A second analyst quoted in the article declared: "I believe we're in the beginning of the start of a long-term bull market." And a third: "It's time to back up the truck and load it up with stocks."

But is all this exuberance rational? Amid all the enthusiasm, could it actually be time to dump your dividend stocks?

Greed and Fear

Investing legend Warren Buffett has often warned investors to be "fearful when others are greedy, and greedy when others are fearful." Lately, greed has been paramount among dividend investors.

To illustrate, take a look at this chart, which shows how dividend-paying stocks in the Dow Jones Select Dividend Index ETF (DVY) have been performing lately. After roughly tracking the performance of the broader S&P 500 index for some years...



...dividend-paying stocks suddenly gained favor last August, quickly leaving the rest of the market in the dust.



Will this trend continue, though? There are at least a couple of reasons to worry that it won't.

For one thing, long-term trends tend to "revert to the mean." This suggests that if dividend-paying stocks are performing strongly today, this could be a foreshadowing of their underperformance tomorrow. Indeed, the recent success of the sector had Barron's itself lamenting earlier this year that the yields on dividend payers had become "stingy."

That's not surprising. With Treasuries paying near historic low yields lately, stocks haven't really had to pay much in the way of dividends in order to look generous by comparison. Indeed, the average yield on the S&P 500 today is a miserly 2%. But one reason for this apparent stinginess derives from how yields are calculated in the first place.

You're Ruining It for Everyone Else!

Consider the case of (imaginary) Pennsylvanian margarine-substitutes researcher Monongahela Original Oleo Laboratories Amalgamated (Ticker: MOOLA). The stock trades for $10 a share and pays a $1 annual dividend -- hence a 10% yield on its stock price.

But what happens if investors suddenly decide that they like this generous yield, and flock to the stock? They bid up the price, and before you know it, Monongahela is selling for $20 a share (a 5% dividend), then $30 (3.3%), and maybe even $40 (2.5%).

Pretty soon, Monongahela's dividend yield is looking as stingy as everyone else on the S&P -- and absent any improvement in earnings, its stock price is looking pretty overvalued as well.

That could be what's happening to dividend stocks today.

Here Be Dragons

Compounding the risk that dividend stocks have become overpopular and overvalued is the potential for government action that could make these stocks very unpopular, virtually overnight.

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Currently, many dividends qualify for a reduced tax rate of 15%. But next year, if Congress doesn't take action, dividends will lose their preferential treatment and instead be treated as ordinary income. In Washington, President Barack Obama is said to be floating plans to allow that tax break to expire, in which case rates on dividend payouts could rise as high as the new top personal tax bracket of 39.6%.

When you combine this new tax treatment with phased-out deductions and exemptions for high-income taxpayers, and add the 3.8% tax surcharge passed to help fund Obama's health-care law, experts say the effective rate on dividend income could soar as high as 44.8% -- or three times the current rate.

Congress might restore the dividend tax break beyond the end of this year, of course. But with our national debt hitting new highs daily, Congress must find funds somewhere to finance its spending. And tweaking the formula for how dividends are treated is less likely to raise a ruckus among voters than actually raising tax rates.

The time to dump your dividend stocks is before that happens. Afterward, it will already be too late.

Motley Fool contributor Rich Smith does not own shares of any companies named above.

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