Only a few years ago, dividend investing was as much out of style as bell bottom jeans. But as we’ve seen in the past, fashion trends are subject to cycles and can experience miraculous resurrections. The same holds true for investment styles. Dividend ETFs were out when growth ETFs were in, and now it’s the other way around.
Dividend investing reached an all time low in 2000 when the major indexes yielded only 1.4%. The years leading up to the ominous tech-crash of 2000 and the subsequent rise of the Dow to 14,000, investors got spoiled with double digit returns and felt that dividends were out of style and unnecessary. Why bring sand to the beach or in other words, who cares about a few percent in dividend payments if you can double your money investing in companies with no earnings.
Dividend yields are not only intriguing; they can also be an accurate measure of the economy’s health. In 1992, for the first and only time in its long history, the Dow Jones (AMEX: DIA) broke below the 3% yield level and remained there for almost 16 years.
As of today, the Dow Jones yields 3.38%. This is more than other popular benchmarks like the S&P 500 (AMEX: SPY) which yields 3.09% and the Russell 1000 (NYSEarca: IWB) with its 2.70% yield or the once high-flying Nasdaq (Nasdaq: QQQQ) which yields only 0.51%.
Such yields are dwarfed by ETFs that yield as much as 12.87%. However, when it comes to dividend ETF shopping, a one-dimensional focus on yield is as reckless as using color as the sole criteria to find a quality car.
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Ironically, the best yields are paid by the worst performing industry sector, financials. The Financial Select Sector SPDRs (AMEX: XLF), a basket of 85 financial stocks, boasts a yield of 6.67%. For 2008, XLF is down 55%. Dividend yields have simply risen as a result of declining valuations in the underlying stocks.
Citibank (NYSE: C) aptly illustrates the dilemma of dividend yield versus risk. On paper, Citi still boasts a 7.78% dividend yield. However, in exchange for accepting the government bailout, Citi was forced to cut its dividend to one penny per share per quarter. To make matters worse, shares of Citigrougp plunged from $55 to $7. How many other companies will face the same fate?
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Below is an excerpt from the ETF Profit Strategy Newsletter – Published on Oct.21, 2008
At the time, the Dow was above 9,000. It dropped below 7,500 and rallied into Nov./Dec
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Market Meter
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Short-Term: published on Oct. 21, 2008
The Dow should find a “trade-able bottom” between 7200 – 7,500
Mid-Term: published on Oct. 21, 2008
Once bottomed, the stock markets will rally into Nov/Dec
Long-Term: >> Sign up to find out
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Consumer staples (AMEX: XLP), 2008’s best performing S&P sector, is down less than 20% which has kept XLP’s dividend yield at a boring 2.51%.
A glance at the list of 38 highest yielding ETFs (available to members of the ETF Profit Strategy Newsletter) reveals that value and sector ETFs at times pay out more than ETFs designated as dividend ETFs.
WisdomTree offers a line-up dividend weighted ETFs. The WisdomTree Dividend Top 100 Fund (NYSEarca: DTN) has essentially matched the S&P 500’s performance over the past year. The iShares Dow Jones Select Dividend Index Fund (NYSEarca: DVY) slightly outperformed the S&P while the SPDRs S&P Dividend ETF (NYSEarca: SDY) was able to outperform by 10%.
A general performance comparison of dividend ETFs vs broad benchmarks shows that good dividend ETFs tend to soften the blow of a bear market while trailing in rebounds and bull markets.
Aside from the yield, dividend paying stocks are often considered safe because of the underlying companies’ financial strength to sustain dividend payments. However, even the 30 U.S. blue chip stocks have not been able to buck the market's trend.
In 2008 alone, three Dow components were replaced (Honeywell, Altria, AIG). Another four components, American Express, Bank Of America, General Motors and Citigroup might soon be on the chopping block. This bear market has changed the rules of investing.
Within the last two days, Morningstar and TheStreet.com claimed that the stock market is undervalued. This is a statement that conflicts with historic dividend yields at the time of major market bottoms.
Nevertheless, if your heart is set on dividend investing, keep the following points in mind:
1) Don’t be one dimensional. Risk management is more important than yields. A 5% yield does not make up for a 20% loss.
2) Yields change. Companies can slash their dividend at any time which often results in panic selling. With a shot of humor, my colleague Ron DeLegge comments about dividend cuts: “Don't worry if your dividends have been cut, management is aware of the problem and is working on it. In the meantime, thank you for your cooperation.”
3) Know what you own. Toxic sectors, such as financials, pay high dividends. High yields come with risks. Be aware of the sector exposure and how sectors behave in various economical environments. For example, financials are beaten down for a reason; consumer staples perform better in a bear market while consumer discretionaries perform better in a bull market.
4) If it sounds too good to be true, it probably is! A double digit dividend yield is unsustainable. Either the price will drop further to “inflate” yields or yields will drop.
If you want to dig deeper and get to the root of the problem, consider the ETF Profit Strategy Newsletter. The December issue includes an in-depth analysis about stock market valuations and at what dividend level historic market bottoms were formed. Today’s update includes a list of 38 high octane dividend ETFs with a simple chart illustrating the risk-reward ratio of dividend investing. A picture is indeed worth more than a thousand words.
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