Dillian: Bubble In Dividend ETFs Looms

November 13, 2013

So the dividend/value/staples trade worked for years and years, and it’s hard to imagine having a “bubble” in real companies with real earnings and real dividends, but it can happen. Nineteen times earnings for Coca-Cola is a bubble, for example, and a lot of folks who say they have exposure to equities really don’t. They have exposure to what is perceived to be the “lowest risk” kind of stocks, and they have been hiding out there for years.

Then, you throw in the proliferation of low-volatility strategies (like with iShares MSCI USA Minimum Volatility fund (USMV | A-54) and the PowerShares S&P 500 Low Volatility fund (SPLV | A-44)) that promise the best ratio of return to risk on a historical basis, but the problem is, when trades like this get crowded, they can become subject to a rapid unwind.

I’m bullish on stocks, but I’m a believer that when everyone thinks alike, nobody is thinking. A continued rally in the stock market is not going to be led by big, old companies that sell out-of-favor products, but by companies that are working on really changing the world—whether in minor ways, like changing the way we eat, how we share information about business, how we communicate with each other, or even companies that are bold enough to want to limit or eliminate carbon emissions.

We are entering a retail phase of the market where aggressive growth stocks (I dislike calling them “momentum stocks”) are bid to stratospheric valuations over the next 18 months, in an echo of what happened 13-odd years ago. And as interest rates inexorably rise, it will make dividend payers that much less attractive.

It’s hard to be short dividend-paying stocks and long growth names, because the trade is strongly negative carry, and most modern financial theory will tell you that the majority of the returns from holding a portfolio of stocks over any length of time come from compounded dividends.

But growth bull markets can be more lucrative if you trade them right. I’m fond of saying you have to pretend you’re dumb on the way up and actually be smart on the way down. It doesn’t take a lot of IQ to fall in love with a stock like Tesla, but it takes a cautious skeptic to know when the valuation has gotten impossibly ahead of itself. (For the record, I own Tesla and am still bullish.)

Zero rates and risk aversion have created a big bubble in dividend ETFs (there literally are dozens of them), and consequently, the underlying names. A huge bull market in low-quality, dividend-less stocks would surprise everyone, so that is what will probably happen.

Of course, over the last 13 years, we have become conditioned to view stocks without dividends as low quality. What if they are just better stewards of the cash then you would be?

Disclosure: The author is short Philip Morris, Coca-Cola and McDonald’s, and long Tesla.


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