I was enduring another dreary drive yesterday on the notoriously congested Washington, DC Beltway when my “fuel empty” indicator started flashing. Did I have enough gas to get home or should I pull over at the first exit and fill up?
Once the empty light comes on, my nine-year-old Volvo sedan can travel about another 30 miles at highway speed before it stops cold dead. I had time to get back to my neighborhood, but it got me to wondering: How much farther can this overvalued bull market run on fumes?
As headwinds accelerate, what’s an investor to do? Consider greater exposure to dividend stocks, which provide the trifecta of safety, income and growth. This class of asset is sort of like my old Volvo: ostensibly “boring” but solid, reliable and beautiful in its own way.
First, let’s look at the market dangers that make dividend stocks compelling right now.
The forward 12-month price-to-earnings ratio for the S&P 500 currently stands at 17.7, a level that exceeds the three most recent historical averages: five-year (15.2), 10-year (14.4), and 15-year (15.2).
The widely followed Cyclically Adjusted Price to Earnings (CAPE) Ratio sports a reading for the S&P 500 of 31.4, compared to the average of 16.9. The CAPE ratio is defined as price divided by the average of 10 years of earnings (moving average), adjusted for inflation.
CAPE, developed by Nobel Laureate Robert Shiller, provides a more meaningful context than the standard P/E ratio. The current CAPE level was topped only during the 1929 market peak, the 2000 dot-com frenzy, and the 2007 equities and housing bubble.
Today’s high valuations are increasingly held aloft by “animal spirits” rather than empirical data. Meanwhile, according to research firm FactSet, the latest projections for second-quarter corporate earnings are negative, at -1.9%.
Stocks fell yesterday from record highs, dragged lower by earnings misses from blue-chip companies. To date, more than 40% of S&P 500 companies have reported their latest operating results. The analyst consensus calls for a contraction in overall earnings, once the final numbers are in. Export-dependent companies, such as multinational manufacturers, are expected to suffer the worst earnings declines because of the persistent U.S.-China trade war and a sputtering global economy.
News remains mixed on the economic front. The government reported Friday morning that U.S. gross domestic product (GDP) in the second quarter slowed to a 2.1% annual pace, compared to a 3.1% gain in the first quarter (see chart).
The main culprit for the slowing pace of GDP growth was shrinking business investment. Companies are retrenching because of tariffs, flagging global demand (especially from China), and fears of a recession.
However, the GDP report also contained encouraging news on consumer spending and beat expectations of 1.8% growth. Both Alphabet (NSDQ: GOOGL) and Intel (NSDQ: INTC) reported earnings Thursday that topped analyst expectations. As of this writing Friday morning, the three major U.S. stock market indices were trading in the green.
In this good news/bad news context, evidence is mounting that tough times lie ahead. Goldman Sachs (NYSE: GS), Morgan Stanley (NYSE: MS) and JPMorgan Chase (NYSE: JPM) have all warned in recent days of a likely stock market correction in the third quarter, due to disappointing corporate earnings and slowing economic growth.
You don’t have to be an income investor to love dividend-paying stocks. Dividend-payers are time-proven vehicles for long-term wealth building, but they’re also safe harbors in turbulent seas because companies with robust and rising dividends by definition boast the strongest fundamentals.
If a company has the low debt and healthy cash flow required to throw off juicy dividends, it follows that the balance sheet is intrinsically sound enough to sustain the firm through corrections.
When doing your homework on a dividend stock, it’s crucial to examine the payout ratio. The payout ratio reflects how much of a company’s net income is devoted to dividend payments. For example, if the company in a quarter generated earnings per share of $1.00 and paid a dividend of 60 cents per share, the payout ratio would equal 60%.
A low payout ratio can indicate the company is pursuing a long-term growth strategy by using most of its earnings to reinvest in the company. On the other hand, a high payout ratio can indicate management’s desire to share profits with investors.
The Beauty of Being Dull…
The so-called “Dividend Aristocrats” always provide a fertile hunting ground for investors. To earn the honorific Dividend Aristocrat, a company must typically have raised dividends for at least 25 years.
These dividend powerhouses constitute the S&P 500 High Yield Dividend Aristocrat Index, an official index of the 50-plus highest dividend yielding stocks in the S&P Composite 1500. This Aristocrat Index is maintained by Standard & Poor’s, which every December updates the list of companies that make the grade.
By its very nature, a Dividend Aristocrat tends to be a large and stable blue-chip company with a strong balance sheet. Many of these companies are familiar names that produce household brands. These companies may seem dull, but their financial stability helps them weather market ups and downs.
For example, during the crash of 2008, the Dividend Aristocrats Index fell 21.9%, compared to the S&P 500’s plunge of 37%. In 2018, the Dividend Aristocrats (-2.73%) outperformed the S&P 500 (-4.38%) by 1.65% (see chart).
The REIT Path…
During the late stage of a recovery, as we’re experiencing, the real estate sector tends to perform well. That makes real estate investment trusts (REITs) good bets now.
In fact, if you’re looking to live off dividends in your retirement, you shouldn’t ignore REITs. By law, REITs must deliver 90% of taxable income back to shareholders.
REITs generally hold their value in a down market because the rents their tenants pay are contractual obligations. Rents also tend to rise with inflation, helping offset its corrosive impact on purchasing power.
When you’re considering REITs, look for those that are consistently growing their funds from operations (FFO), which is how a REIT reports earnings. Because FFO doesn’t include gains or losses on property sales, nor depreciation, the metric gives you an idea of how a REIT is faring on a real cash basis.
My friends who prefer snazzier, newer cars like to tease me about my Volvo. True, it’s not a sexy car, just as dividend-paying stocks aren’t as sexy as the technology “story stocks” that get hyped on CNBC. But like my battle-hardened Volvo, dividend stocks get you where you need to go…safely.