Black Swan fans are always looking for the next bubble to burst
Here’s a theory for Black Swan fans; dividend stocks are the next bubble to burst and it will happen at the moment interest rates will rise.
Supporting the Theory
Since 2008, interest rates have dropped to the lowest level ever in North America. Insurance companies, pension plans, institutional investors and income seeking investors were all in the same basket; the lack of safe and reliable revenues from their investments. You can’t do much when 5 years bonds pay less than the rate of inflation. What can you do? Look elsewhere.
While dividend investing has always been very popular throughout the history, dividend stocks have caught more attention over the past 5 years. After the stock rebound in 2009 and 2010, dividend stocks appeared to be the next savior for income seeking investors. They realize that a well-diversified companies like Johnson & Johnson (JNJ) or Procter & Gamble (PG) are super stable companies generating more than interesting yields. At one point, some investors started to compare municipal bonds paying 2% for 5 years while JNJ and PG and a whole bunch of solid dividend stocks were paying over 3% in dividend yield. And the best part was the growth potential; strong dividend stocks will increase their dividend payment year after year on top of providing stock value appreciation. Wow… this sounds better than bonds, right?
And this is how massive amount of money started to fly away from bonds to be invested in dividend stocks. At that moment, we saw an increase in valuation multiples for several companies. Just look at the chart below:
As you can see, the PE ratio increased significantly over the past 5 years for many stocks known for their strong dividend payment history.
What happens when valuation goes up like this? You are right; it has to drop as fast as it went up. Well… that’s the Black Swan fan theory anyways…
Once interest rates will start to rise, this important group of income seeking investors will rapidly sell their dividend paying shares to replace them with solid bonds paying decent levels of interest. If many institutional investors follow this trend, we will have a crash in the dividend stock world as we will see too many sellers for so little buyers.
I’m NOT Supporting this Theory
I don’t know if you are starting to think that I believe dividend stocks will be the next bubble to burst, but I’ll make it clear: dividend stocks are not a bubble. I’m not a big fan of Black Swan events and I don’t think the stock market will collapse due to overbought dividend stocks.
Not fast enough to create a crisis
The first reason why this scenario won’t happen is because interest rate won’t rise overnight to 5%. The FED is very cautious with the interest rate and this is why rates haven’t risen yet. It will happen in 2015, that is almost a certainty. However, rates won’t increase by 0.25% each month for the next 36 months either. The economy is not booming and the inflation rate is under control. Therefore, while a healthy economy requires higher interest rates, there are no reasons to boost rates like there is no tomorrow. This would probably do more harm than anything else anyways.
If the interest rate goes up slowly, there won’t be a massive movement of cash going out of dividend stocks to buy bonds. It will be done slowly and massive share buyback programs authorized within the same dividend paying companies will probably be enough to compensate for the outflow.
Dividend stocks remain strong companies
It is true that we have more investor types that invest in dividend paying stock these days due to lower interest rates. However, dividend stocks are popular for a very simple reason; dividend stocks are strong and reliable businesses generating constant cash flow. Therefore, it’s also normal that their valuation multiple increased over the past 5 years. A good part of this was simply the dividend stocks following the general stock market trend where investors are more optimistic about future growth in general. This is not a phenomenon that implies solely dividend stocks.
Also, there is a basic reason why most companies that pay a dividend do it; it’s because they have a solid business model enabling them to do so. And this solid business model won’t collapse if some investors sell their stocks to buy bonds. Solid fundamentals won’t be affected and if the stock price drops, it will only be a great buying opportunity.
Final thoughts on this potential bubble
I can’t guarantee there won’t be a panic movement around dividend stocks at one point. You know Mr. Market’s mood swings are pretty violent some times. However, I don’t see a valid reason why dividend stocks would lose value over the long haul. Therefore, if there is a storm, the dividend payment will protect you in the meantime and the sun will shine again.
If you can put some cash aside (I’m not saying you should sell, but rather save more money for the next round!), I think we will see a great buying opportunity coming shortly! Thx to the Black Swan fans!!
What do you think? Do you expect dividend stocks to drop suddenly once interest rate starts to rise?
Disclaimer: I own shares of JNJ and KO
Hi Mike. Hope you enjoyed your RVing weekend. I wrote a piece two weeks ago on this very issue. I don’t think all dividend stocks are grossly overpriced, but I do believe that certain sectors (like Utilities, Railroads, and a few Consumer Staples companies) were in bubble territory a few months ago. I bought Union Pacific for instance 25% below it’s high for the year. I expect the share price to continue lower, and will average down around $90. These companies should not be selling at PEs in the 22-25 range. Companies in these sectors can’t grow fast enough to justify such valuations.
I am ready to jump in with my dry powder however. I am really hoping to load up on REITs and companies like JNJ. The best opportunity I see at the moment is Agricultural commodities. I’ve put a large portion of the speculative side of my portfolio to work in this space. Like you implied, long term investors should get great opportunities when the hot money leaves the dividend growth space.
Have a great week
-Bryan
Hey Bryan!
thx for the additional info! With what is happening with Greece this week, it will be interesting to see more buying opportunities. I think it’s a matter of time before Mr. Volatility comes back around 😉
Cheers,
Mike.
oh and yes, the RV weekend was amazing!
I’m coming back with an article this week 🙂
This is something we talk about a lot behind the scenes at SA.
The chart above is a little bit deceptive, as it shows average P/E’s of companies whose growth qualities are not entirely equal. Kimberly-Clark saw a drop in net income last year, so the increase in P/E is simply the price of the stock not falling in step. In the same time period, 3M increased their earnings, and didn’t see the price come up at the same rate.
Now that aside, I wanted to address what you said about interest rates and the possibility of fixed income creating relatively attractive yields. That’s not the reason I’m concerned. At least, not the primary reason; because a relative yield does matter, but for the time being, it’s going to be against similar classes of investments. Treasuries vs. Junk bonds for example, the junk will be slaughtered as rates come up.
The major reason I’m concerned about dividend growth stocks is that a large number of companies have leveraged up on cheap debts. Moving forward, if debt starts to cost more (And this is happening, note the change in the 10-year over the last month, even without the Fed making adjustments), then these companies will not be able to maintain the same profit margins without some price inflation coming into play.
Stagflation is the black swan. If we don’t see some pricing power coming into play soon, then dividend growth stocks are in trouble. So don’t sweat the P/E ratio so much, but do sweat the balance sheet, and do give extra weight to those high quality brands.
Hello Matthew,
thx for your well detailed comment!
I agree with you that if we get into stagflation, it will be the beginning of a very bad run on the market. However, the problem won’t solely affect dividend growth stocks but the overall stock market.
In addition to cheap debt that could become a problem, I also keep an eye on massive share repurchase programs keeping stock value artificially higher. Since debt is cheap, many companies repurchase their stocks to please investors over the short run. It’s never a good idea to please investors! Management should concentrate on growing their business instead of growing the stock price.
Cheers,
Mike