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What Dividend Yields Are Telling Us Today

Josh Peters, CFA

Josh Peters: Hello, this is Josh Peters, editor of Morningstar DividendInvestor. Dividend-paying stocks have some wonderful attributes that just about any investor can appreciate. They generate income that you could use in your retirement or to build earning power for the future. Dividend increases provide very good signals that the company that you own is healthy. Just having the dividend itself shows you that the company has some cash or access to cash. As we can see from some past scandals, that's not always the case with reported earnings.

But what can we say about a market that, at least over the last couple of weeks, seems to have set a new post crash high just about every day? Is this a good time to be getting back in, or is the market too expensive? Should investors be waiting for a pullback?

Well, these kinds of questions apply to just about any kind of investor, whether they're looking for income or not. Dividends provide a useful framework to start thinking about some of these questions, even when we've come through such a turbulent period as the one we've just had.

Now we might start off by looking at what dividends are telling us right now. Well, the fact of the matter is that dividends are telling us about the same kinds of things they were telling us five or 10 years ago, which is that stock prices, relative to the amount of dividend income you can expect, are still relatively high.

You might think of it in terms of a P/E, with its dividend yield of the S&P 500 at about 2%, investors are paying 50 times dividend earnings for their portfolios for their investments. The good news is that not all companies have dividend yields as low as two percent.

It's not uncommon to find three, four, five, six percent even these days, and that provides an investor with the opportunity to get a lot more income for their dollar, which in turn, takes some of the pressure off of looking solely at price appreciation to drive your total returns.

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And while it is true that dividends are more expensive now to acquire in the sense that stock prices have gone up faster than dividends over the last six to nine months, there are still some reasonable deals around. Not what I'd call bargains, but reasonable deals.

Looking forward, though, the kind of portfolio that you want to put together for yourself with dividend paying stocks, or even with any other kind of security, is going to say almost as much or perhaps even more about you as an investor as it does about the market.

One thing I would definitely suggest investors not do at this point is to simply take all of their ready money and plunk it right into the stock market at its current level. There is nothing to suggest that this is a bargain price level for the stock market where you have a really good probability of really good returns going forward; an OK probability of fair returns is probably more like it. So you don't want to stake your entire capital to one price level.

A better idea might be to average in, perhaps over a period of weeks, or better yet, months. If we have a correction, you'll have the opportunity to acquire more shares with the same dollars at a lower price.

If the market continues to move up, you haven't missed the whole thing. And here's again where dividends come in really handy. If you're not retired and you don't have to draw on your dividends to supplement your retirement income immediately, the dividend income you're receiving gives you the opportunity to reinvest. And in this way, lower stock prices can actually be more valuable than higher stock prices.

Just to use an example, imagine the average stock that trades at a two percent yield, or 50 times dividend earnings for its shareholders. If investors have the opportunity to say, buy that stock after it's fallen by a third, and now it trades at 33 times dividend earnings, or a three percent yield, you're getting more income for your dollar.

You're getting the opportunity to reinvest and compound those dividends at a faster rate, with stock prices being lower. But perhaps the most important point that you want to recognize about dividend paying stocks is that even though they generate income, not unlike a bond or a CD or some other type of fixed income investment, a dividend paying stock is still a stock.

It's still an equity stake in the business. You're only going to get paid from that business as an investor after everybody else has already been paid before you. All creditors, employees, even the IRS all stand in line ahead of you to get paid. So in that sense, you have to think like the long-term owner, in part, of a business.

You can't own a stock like you would a CD or a bond, or perhaps just a savings account. For that reason, it's important to keep that long-term relationship in mind. When you're looking at dividend-paying stocks or any kind of stock, you want to think, "Is this something I want to be a part of for the next five or 10 years?"

One mistake that I think a lot of investors may be making right now is to look at current interest rates, almost zero percent, virtually zero percent on a money market fund, and say, "Well, I've got to be able to do better than that in the stock market even if the average yield is only two percent."

That's a big mistake. You don't want to mix up cash and stocks. You want to think about your portfolio in terms of here's what I can allocate as a long-term part owner of a business, and then here's the ready money that I need to have in case something goes wrong. If you put that ready money into the stock market, you may find out there's less of it there when you need it.

So just to recap, don't feel like you need to get back into the stock market just because prices have come up, and you don't need to feel like you've missed a tremendous opportunity, either, especially if you didn't bail at the bottom.

Today's stock market offers some OK values, some opportunities to put capital to work on reasonable terms, but if you're thinking as a long-term partner in a business, and you're thinking about how much of your portfolio you're willing to devote to these stocks, and you employ a strategy that allows you to average in and take advantage, perhaps, of any kind of correction or price decline that we may have, you can still make the stock market work for you.

For ideas on individual securities that might help you meet these goals in your portfolio, check out a free trial copy of Morningstar DividendInvestor, which you can access by clicking on the link below.

With that, I'll thank you for listening. It's been Josh Peters, Editor of Morningstar DividendInvestor.