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Are Dividend Yields Stuck on the Small-Portion Menu?

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January 15, 2015

The U.S. bull market’s record gallop has surely been a feast for many investors’ eyes.

Yet, if you’re a retiree or someone else who depends on a stock portfolio to generate a dependable stream of dividend income, you could be forgiven if you feel like you’re looking at a “tapas” menu. That’s because as stock prices rise, dividend yields typically move in the opposite direction. 

Indeed, stocks in the Standard & Poor’s 500 Index had an average dividend yield of about 2% last year, according to S&P Dow Jones Indices, down slightly from an average of 2.09% for the past 10 years (and barely above the annual rate of consumer inflation).

Amidst the headlines over the market’s stratospheric levels, it’s tempting to think dividends have become an afterthought. But that’s not the case. Dividends remain an important factor to consider in portfolio strategy and can offer insight into the overall market. Here’s a few things to keep in mind.

History Divided

Dividend yields for the broader market have ground along at historically low levels for much of the past two decades. During that time, fewer and fewer companies offered dividends, and many that did kept them relatively low.

However, there was a time when dividend yield trends were seen as possible harbingers of market tops and bottoms. If the S&P 500 dividend yield fell near 3%, for example, it might signal a market top was near, while a yield above 6% could be the sign of a bottom (see figure 1).

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FIGURE 1: YIELDS OVER TIME.

Annual dividend yields for the S&P 500 ranged from 3% to nearly 8% in the decades following World War II, then, starting around the mid-1990s, slipped to the 2% area. Source: irrationalexuberance.com, Robert J. Schiller. For illustrative purposes only. Past performance does not guarantee future results.

Utility Players

Let’s clear something up: Rumors of the dividend’s death have been greatly exaggerated. You just have to dig a little deeper to find the gems and not take conventional wisdom at face value. For example, utility stocks have long had a reputation for relatively high yields, and that’s still largely true. In 2014, utilities in the S&P 500 posted an average dividend yield of about 3.4%.

But it was actually telecommunications services that led the pack at an average of nearly 5.1%, tops among 10 S&P 500 market sectors (see figure 2). Let’s not forget about publicly traded Real Estate Investment Trusts, or REITs, which can sport yields well-into the teens but also carry additional risks beyond traditional stocks and bonds.

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FIGURE 2: PHONE HOME. Telecommunications services shares (red arrows) had the highest dividend yields among S&P 500 sectors in 2014, more than double the broader market average (yellow). Source: S&P Dow Jones Indices. For illustrative purposes only. Past performance does not guarantee future results.

Getting Interesting

Interest rates hovering near historic lows in recent years boosted the appeal of REITs. But change is in the wind, with the Federal Reserve expected by many to hike benchmark short-term rates later this year. Since the late 1990s, REIT returns outdid even the highest-yielding stocks, according to research by Morningstar, Inc.

But REITs, being linked to real estate, are particularly sensitive to interest rate fluctuations and can behave like bonds, meaning when rates rise, prices fall. So, keep a close eye on the Fed’s signals in coming months, as well has how key market gauges, such as the 10-year Treasury yield, respond.

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FIGURE 3: SIFTING & SORTING. The Stock Screener, located under the Research & Ideas tab on tdameritrade.com, can help sort stocks by dividend yields and other metrics. Source: TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.

Portfolios that Pay

Investors seeking diversification and reduced risk often look to low correlations between stocks and bonds, and the latter historically has displayed lower risk. Still, based on Morningstar research, investors ignoring income investments likely lost out on greater returns in recent years. Dividend-paying stocks returned about 6.8% annually in the 15 years through 2012, compared with 5% for non-dividend counterparts, according to Morningstar.

Ultimately, hunting dividends is a lot like other aspects of sound investing, such as doing your homework and proceeding judiciously. Keep in mind that a dividend payout doesn’t necessarily make a stock an income darling. Don’t fall into the trap of focusing only on growth, and remember that reinvesting dividends can be part of a growth strategy. A rising-rate environment makes it imperative to recognize where the strongest dividend growth may be and learn how to separate the men from the boys.