Are Dividend Stocks the Next Bubble?

Dividend stocks are leading the market and some pundits believe the rally is a bubble about to end badly. But they may be underestimating the flood of income-starved retiree money heading this direction in a record low-yield environment.

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Dividend-paying stocks have been on a tear, and if you believe the experts it has all gone much too far. We are now in yet another bubble, this one comprising just about any stock with a yield. Look out below.

Certainly, there is reason to take notice. In the last three months, traditional dividend-paying industries including telecom (13.7%) and utilities (7.5%) have far outperformed the broad S&P 500 (-1.2%) and individual sectors like materials (-3.4%) and financials (-5.4%).  The Wall Street Journal reports that dividend-payers are now valued in the market at 25% more than non-dividend payers.

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And the money keeps rolling in. From The Journal:

“Investors have plowed a net $16 billion into U.S. dividend equity funds since the beginning of the year, with inflows picking up in recent weeks. By contrast, some $25 billion has been withdrawn from non-dividend funds, says data tracker EPFR Global.”

So something is afoot. But every rally is not a bubble. What’s happening to dividend stocks seems analogous to the housing market in, say 2002. That’s when the bubble talk began and, of course, a bubble was building. But it took another five years and prices rose another 50% before the bubble burst. Even with the brutal decline since 2007, most who bought real estate in 2002 are about even.

Bubbleologists may be misreading the dividend frenzy. Wall Street generally attributes the latest rush to dividends as a result of the persistent Euro crisis and recent hiccups in the China growth story. Fearing a global slowdown, the thinking goes, investors are shifting out of economy-sensitive stocks into sectors like healthcare and consumer staples—considered defensive because of their steady cash-flow even in hard times and their commitment to paying a dividend.

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Yet this defensive shift is but a small part of the story. What’s really driving the trend to dividends is the low yield environment that has retirees, especially, so desperate to secure an income stream that they have begun moving up the risk ladder. The 10-year Treasury bond just hit a record low yield of 1.4%. The average savings account now pays .19% and the average money market rate is just .22%. Those who invest for income have been living a nightmare, and many simply can’t tolerate it anymore.

To Wall Street, these unsophisticated yield chasers make it feel like a bubble. In this view, the dumb money is last to move in—and at just the wrong moment. From the Seeking Alpha website:

“There is a risk that inexperienced investors, turning to dividend growth stocks in their search for yield, may be walking into an over-valuation trap.”

That is, of course, a possibility. But it seems more likely that Wall Street is underestimating the degree to which individuals—retirees, most notably—will continue to flood into dividend stocks as long as rates remain so oppressively low. Income seekers don’t have a lot of great options. So it may be a bubble. It may become a bubble. But like home prices in 2002, this bubble won’t burst for a while. A sharp uptick in interest rates would do it—but that’s not going to happen as long as the global economy limps along.

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