Dividend Stocks in a Low Interest Rate World
The Federal Reserve's current policy of maintaining low interest rates and purchasing securities via quantitative easing increases the difficulty of deriving income from securities with a reasonable amount of risk because these actions have increased asset prices. Shopping basics teach us that buying a good for a cheaper price is preferable to paying a higher price. During the Federal Reserve's first round of quantitative easing, equity prices rose over 50 percent. Since last fall's announcement of quantitative easing 2.0, equity prices have risen an additional 30 percent.
When the Federal Reserve's policy is combined with the Federal Government's spending policy, you can see why investors are buying gold and silver as a hedge against the risk of future inflation. As a result of today's policy dynamics, investors are struggling with what to do with money that normally might be invested in cash, CDs or bonds. Many questions are being asked as to whether the solution is oil and gas-related Master Limited Partnerships (MLPs), foreign bonds or dividend paying stocks.
One of the difficulties in investing is that the future is never exactly like the past or the present. Investments which look reasonable given the current conditions often disappoint in retrospect because future conditions will by definition be different than today. Further compounding the issue, financial firms generally market investments based on the recent past or current conditions.
As an example of this let's consider three investments: the Dow Jones Select Dividend Index, the Standard and Poor's 500 Stock Index and gold. One pays a higher than average dividend, one pays the average dividend and one pays no dividend. All three are available to be purchased through an Exchanged Traded Fund (ETF). The DJ Select Dividend Index is an index of one hundred dividend paying stocks, ranked by the indicated annual dividend yield.
From its December 1991 inception through March 2011, the DJ Select Dividend index returned 11.5 percent per year. Over that same period, the S&P 500 returned 8.33 percent per year and gold returned 7.56 percent per year. Over the last ten years, however, the performances are 6.28 percent, 3.29 percent and 17.93 percent a year respectively. While this long term performance is certainly impressive, investors should also consider the following facts: during the recent crisis, the dividend index fell more than the broader market or gold (-56.61 percent, -50.95 percent, -34.32 percent) and is further from its all-time highs (-18.29 percent, -8.23 percent). Gold meanwhile is 40 percent higher than its pre-crisis highs. The dividend index also suffered two consecutive negative years (2007 & 2008), while the S&P was down in 2008. Gold has not had a down year in the past decade.
Why this disparity in performance? Logically, each is exposed to different risk factors. For example, the DJ Select Dividend Index is more exposed to industries like financials and utilities while the S&P 500 is more broadly diversified. Gold is more exposed to interest rates and inflation expectations.
All assets, including dividend paying stocks, MLPs and foreign bonds, can be good investments provided that the prices paid are low relative to the risks that might occur in the future. When constructing an income-oriented portfolio, you should continue to observe best practices regarding diversification even while searching for yield. For example, in addition to considering dividend yield, make sure there is not an overreliance on particular sectors or companies. One should also screen for companies that have low dividend payout ratios, as these companies will be better able to sustain or increase their dividends in the future. Many asset classes like MLPs and REITS have high yields but are required to have high payout ratios, limiting their future growth. Even if your objective is income, the principals of diversification and buying low should still be applied.