Are Dividend Stocks the Market's Riskiest?


One way to think about the market is in terms of money flows between assets with different risk characteristics. When times are good, money moves out of bonds, which are perceived as safe because bondholders take priority in liquidation proceeds, and into stocks, which are riskier because their owners are last in line. When times are bad, it's the opposite.

The same can be said within asset classes as well. Riskier bonds, known as junk bonds, are more popular when the economy is perceived to be safe, while safer stocks (generally those that pay high dividend yields) demand higher premiums when times are tough. With that in mind, it should be no surprise that the latter are trading for higher multiples than ever.

The conversation about a "dividend bubble" began in earnest at the beginning of last year. As my colleague Morgan Housel said in February 2012, "there's an argument to make that, just as investors ran blindly into subprime bonds five years ago in search of yield, they're running blindly, carelessly into dividend stocks today."

Morgan cited a number of examples to support his case. Consolidated Edison , a utility stock that pays one of the best yields on the S&P 500 , had returned 50% in the two preceding years. And shares of Altria were up by roughly the same degree despite a "string of dismal earnings reports as smoking rates decline."

It wasn't just market commentators who were thinking along these lines. Here's a chart from Google showing the popularity of the search term "top dividend stocks." As you can see, it started to gain traction in the middle of 2007 and has accelerated in popularity since.

So where are we now? Has the bubble popped? Has it deflated? Was it much ado about nothing?

According to Seth Masters, the chief investment officer of Bernstein Global Wealth Management, things have gotten worse. In a recent report from Bloomberg News titled "Desperately Seeking Safety," Masters argues that the "asset classes investors now consider safe havens -- gold, bonds, and dividend-paying stocks -- are dangerously overpriced."

Here's what he had to say about dividend stocks in particular:

Q: What do you see as the risk to dividend stocks?

A: Many stocks with high dividends don't have growth potential. Their payout is their primary appeal. Utility stocks, for instance, [are perceived to] have safe dividends. So a lot of people are buying them.

Recently they were trading at a 50% premium to their historical average valuation. That's their biggest premium ever. Most utilities are heavily leveraged, strictly regulated, and very sensitive to changing energy costs. That doesn't sound like a safe investment to me. But people perceive them as safe and are giving up some good returns in other places to buy them.

To add substance to this argument, here's a chart comparing the historical price-to-earnings ratios of some of the more popular dividend-paying stocks on the S&P 500. The valuations for utilities such as Duke Energy and Consolidated Edison haven't let up since the financial crisis, far outpacing even the safest of American companies, such as McDonald's and Caterpillar.

DUK PE 10 Chart
DUK PE 10 Chart

DUK P/E 10 data by YCharts.

The bottom line here is that a flight to safety may not, in fact, be a flight to safety at all, assuming that these valuations will ultimately come back to their historical norms.

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John Maxfield has no position in any stocks mentioned. The Motley Fool recommends and owns shares of McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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