April 13, 2006
Weighing Risk and Opportunity in Dividend Stocks
By Brady Willett

In 2002-2003 the US interest rate outlook was clouded by the threat of deflation.  For lack of a better way of putting it, interest rate forecasters had no clue about the future, and this led to volatility in the bond market. Since 2004, with the Fed having successfully engrained into the markets the idea that ‘measured’ rate hikes could be handled with deft precision, volatility in the bond market has disappeared.


Suffice to say, with the Fed probably nearing the end of its rate hiking campaign, commodity prices booming, and a slow down in the interest rate sensitive US housing market a potential threat to economic growth, uncertainty is showing signs of returning to the US bond market.  This uncertainty is of great interest to dividend investors.

Risky Stocks Yield Less Than Safe Bonds

That the average US utility stock offers a dividend yield lower than the 10-year Treasury should be a little worrisome to the utilities investor.  More troubling still is the fact that in March 2006 the average yield on all publicly traded REITs (as measured by NAREIT) fell below the yield on the 10-year Treasury for the first time in nearly a decade.  Put simply, that dividend stocks are yielding the same or less than the long-bond means that any rise in US interest rates could lead to a decline in perfectly priced dividend stocks

Before getting overly worried, it is worth remembering that market rotation has been the order of the day since the 2000 bear, and so long as money stays in the markets it is unlikely that companies with solid dividends will fall as greatly as their dividendless counterparts during even the most severe of bears. With the exception of the 1974 bear, a quick look at history confirms this theory: during the ‘stagflation 70s’ and the 2000-2002 stock market bust, investors swarmed into dividend paying stocks (and REITs), pushing the yield on these companies lower compared to the 10-year bond yield.


A closer look at price performance paints less rosy picture, with REITs being crushed not only during the 1974 bear, but also during the 1987 crash and early 1990s recession. Oddly enough, the onset of the 2000 bear market marked what looks like a major bottom. 



Recent History: Utility Stocks Eye Interest Rates

The XLU index limped into the end of 1Q06, closing at a year-to-date low of 30.83 on March 31. However, with quarter-end window dressing coming to end and/or fund managers less apt to sell their losers, utility stock rallied at the start of 2Q06.  GXP, which is one of the highest yielding utilities, gained more than most utility stocks to begin the quarter.


But alas, the rush into utility stocks, which have been one of the strongest performing industries in each of the last two years, was not meant to last. Rather, with US long-term interests taking a jump higher late last week utility stocks have taken a sharp step lower.  As for GXP, that it has held up better than the XLU is of little comfort given that its share price is off by more than 2% over the last 5-sessions. 



Conclusions and Speculations

Researching dividend trends in US stocks is extremely trying (see the debate on ‘equity premium’). For example, the dividend yield on the S&P 500 hit an all-time low of 1.12% in 1Q00 and a multi-year high of 1.94% in 3Q02. This trend – of rising dividend yields during the bear market - is the exact opposite trend seen during the same time in REITs, Tobacco stocks, and many traditional dividend stocks. As for studying utility stocks, it is worth remembering that they can be impacted not only by changes in US interest rates, but also by volatile energy prices, regulatory changes, and Enron.

As vague and contradictory as history is, it is undeniably true that investors have become more attracted to dividends since the 2000 bear market and Bush’s dividend tax cut. Moreover, given that when stocks declined in 2000 and 2001 money did not move out of stocks (ici.org), there is reason to believe that there will not be a quick exodus of capital out of stocks during the next bear market. 

Obviously any outlook for dividend stocks depends upon how high and how rapidly you see US interest rate rising.  If you think not much higher and quite slowly, like I do, the conclusion is that dividend stocks are not due for another 1974-style route.  As for a larger run into dividend stocks and even lower yields (compared to bonds), that may be wishful thinking.

In short, uncertainty in the US bond market is of great interest to the dividend investor. Unfortunately there are no interesting conclusions to be made at this time; only that investors should expect more of the same (i.e. that while rising US interest rates can hurt dividend stocks a large run-up in interest rates is unthinkable given the damage it would unleash in the US economy). What this means for GXP is that while there is opportunity to be found in the company’s dividend, don’t be surprised by share price weakness so long as the risks remain slanted towards rising US interest rates.

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