When markets go up, things are good. Traders are happy, people feel wealthier, and euphoria blooms - except for the dividend seeking investor. Here's why rising markets are bad news for income seeking investors.
To the speculator and day trader, rising markets are a form of euphoria that generate excitement and further speculation. Markets that rise give the feeling that one is wealthier, regardless of the paper nature of the profits or the underlying business value, which may not have increased at an equivalent rate.
Conservative investors who look for safe and sustainable high-dividend yields in order to produce income have a different view on rising market. A rising market makes dividends more expensive. As general securities prices increase, a larger increase is required in an underlying dividend just to maintain parity.
For example, if Wal-Mart (WMT) trades at $50, and pays an annual dividend of $1.21, the dividend yield is 2.42% (dividend divided by stock price). Assume then that there is a rumor that competitor Target (TGT) wants to buy Wal-Mart (WMT), and the price of Wal-Mart shares increases to $60, or 20%. At the new price of $60, the dividend yield is now 2%. In order for the yield to return to 2.42%, the dividend will also have to rise by 20%. And therein lies the problem: increases in stock prices are determined by market forces and emotions, while dividends are determined by underlying business success. Management may have full control of the company and run a highly efficient operation with liberal dividends, but in most cases they have no control over stock price movements.
As stock prices rise, dividend yields decline, making dividends more expensive.
On the other side of the coin, a decrease in stock prices makes dividends more attractive. Strong businesses with excellent dividend histories can sometimes be bought at yields much higher than average, due to short-term market concerns. Take for example Intel (INTC), which in the last twelve months has been as low as $15 (May 2009). At that price, the yield would have been 4.2% as compared to the current yield at a stock price of $22.55 of 2.96%.
Dividend investors primarily seek to produce regular income at a lower risk level, and protect principal. Usually, they also have a long-term time horizon (three to five years) and do not actively trade in and out of stocks (which by definition would not make them a dividend and income seeking investor). A thorough analysis of any potential portfolio inclusion is necessary before buying based on yield.
A great place to start is the Dow Jones Index, which contains 30 of America’s largest and most successful companies. Many of these stocks yield more than 4% (more than twice the average savings account) and represents businesses where principal is secure (given the time horizon). There’s also the added benefit of small gains in principal, likely higher than inflation, over the same time period if patience is present and research has been done accordingly.
Dividends represent a much more lucrative income stream for the conservative investor as opposed to savings rates or CDs. The risk is higher but can be mitigated and with a long-term outlook, investors would find it very difficult to go wrong with a strong and sustainable dividend payer.
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