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Dividend stocks are all the rage.America’s corporations are sitting on tons of cash. And with limited growth prospects and low interests rates, they have no other options but to return that cash to shareholders in the form of share buybacks and dividends.
Conservative investors love dividend stocks because they are perceived to be safer than stocks while offering the diversification away from bonds.
But lately, both of the characteristics mentioned above are becoming less true.
“The widespread pursuit of safety in high-yielding stocks has driven up their valuations and increased market concentration in these stocks,” writes AllianceBernstein analyst Joseph Paul in a post titled Are High Yield Stocks in Bubble Territory. “It has also caused an alarming surge in their correlation to bonds, so investors may be getting a lot less diversification than they realise.”
Here’s what Paul said about high-yielding dividend stocks are becoming more risky:
What’s more, high-yield stocks now account for a much bigger share of the market, elevating the risk that arises when the market becomes overly concentrated in an overpriced subset—such as technology stocks in the late 1990s. In the US, where this trend is most pronounced, stocks with yields 20% or more above the market’s now account for 44% of the S&P 500 Index on a cap-weighted basis. That’s their highest share in the last three decades and well above the historical average of 36%, as shown in the display just below.
Here’s a chart:
Here’s what he said about the fading diversification benefits:
More menacing is the extent to which high-yielding stocks are behaving like bonds. Correlations between the relative returns of the highest-yielding S&P 500 stocks and total returns of 10-year US Treasuries have soared to 80% on a two-year-trailing basis. That’s more than 11 times its historical average of 7%, as shown in the second display, below. That’s the highest it’s been in more than 60 years. This means high-yield stock investors may be far more exposed to bond-market risks—such as an eventual rise in interest rates—than they want to be.
“Investors who are passively invested in cap-weighted indices should pay attention to these trends, too, because the market embeds the growing dangers of overexposure to expensive safety stocks and higher-than-usual correlations to the bond market,” writes Paul.
In other words you may be putting your portfolio at risk of missing out on future returns.