Dillian: Bubble In Dividend ETFs Looms

November 13, 2013

Investors plow into dividend stocks and ETFs, to their peril.

Jared Dillian is the editor and publisher of The Daily Dirtnap, a market newsletter for investment professionals, and the author of “Street Freak: Money and Madness at Lehman Brothers.”

“Super Size Me,” the movie by Morgan Spurlock about McDonald’s and its unhealthy hamburgers, is one of my favorites, even though I really loathe the busybody documentary genre. I still laugh at the scene where Spurlock tries to eat an impossibly huge super-sized McDonald’s meal in his car and ends up vomiting out the window.

Beyond being laugh-out-loud funny, the movie is remarkable in how accurate its predictions about obesity were. The movie actually underpredicted how overweight people were going to get, and without realizing it, was way out in front of the idea that fast-food companies could offer food with very-high caloric and fat content very cheaply. Watching it almost 10 years hence, it was really ahead of its time.

So if you, as an investor, had seen this movie in 2004, you might have been compelled to sell short shares of McDonald’s in anticipation of a wave of lawsuits and regulation. Certainly, there have been lawsuits, and public perception of fast-food operators has been declining for years, but that would have been a terrible trade. The stock is up more than 300 percent since then.

And then you have Coca-Cola , whose product, when consumed in excess, is known to cause diabetes, a huge public health problem—and the stock just relentlessly puts in new highs. Here is a company with almost zero prospect for growth, already operating in nearly every country in the world, whose product is facing an imminent threat of regulation, and yet the stock trades at 19 times earnings. I wouldn’t want to pay 19 times for a no-growth company with a flawed business model, but people are doing it.

And finally, you have the example of the tobacco companies, who, after being hit with a master settlement agreement in 1999, have been paying off hundreds of billions to state governments for more than a decade, in addition to being forced to submit to the strictest regulations possible. And the stocks are up about 10 times since then. Meanwhile, e-cigarettes pose an existential threat to their business model, and with the exception of Lorillard (LO), few of the tobacco companies really seem interested in addressing this challenge.

What is going on? Well, to a large extent, consumer staple stocks like McDonald’s, Coca-Cola and Philip Morris were sort of backlash against the worst excesses of the Internet bubble, where investors went to the other side of the style box and lived there for 10 years. Suddenly it became cool to have a real company with a real product and real earnings, and more importantly, a real dividend.

And those dividends became of crucial importance when short-term (and long-term) interest rates reached cycle lows. A 3-4 percent dividend on a consumer staples stock looks amazing when held up against 10-year Treasury notes yielding around 2 percent.

Plus, if you recall, lowering taxes on ordinary (qualified) dividends was a big part of President George W. Bush’s re-election strategy, and quite literally, the day after the 2004 election, investors plowed into high-dividend stocks and dividend ETFs, like the iShares Select Dividend (DVY | A-67). I was there, trading ETFs at Lehman Brothers at the time, so I remember it well.


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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