Why It's Time to Dump Your Dividend Stocks

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General ElectricWith 10-year U.S. Treasury bills paying less than 2%, there's a lot to be said in favor of owning dividend stocks rather than bonds these days.

The Dow Jones Industrial Average's (^DJI) surge to 13,000 (and beyond) means that fans of capital gains are also sitting pretty. And according to a recent poll of financial experts conducted by Barron's, dividend-paying stocks are the place to be, because they offer the best of both worlds -- a dividend payment today and a higher stock price tomorrow.

In the magazine's annual report on the "top 1,000 financial advisors," recommendations to buy shares of generous dividend payers such as General Electric (GE), Merck (MRK), and AT&T (T) featured prominently. As one member of Barron's illustrious 1,000 boasted: "Ninety-five percent of everything we buy pays us in some form of dividends or interest." And it seems investors are in no hurry to change that.

Why not? A second analyst quoted in the article declared: "I believe we're in the beginning of the start of a long-term bull market." And a third: "It's time to back up the truck and load it up with stocks."

But is all this exuberance rational? Amid all the enthusiasm, could it actually be time to dump your dividend stocks?

Greed and Fear

Investing legend Warren Buffett has often warned investors to be "fearful when others are greedy, and greedy when others are fearful." Lately, greed has been paramount among dividend investors.

To illustrate, take a look at this chart, which shows how dividend-paying stocks in the Dow Jones Select Dividend Index ETF (DVY) have been performing lately. After roughly tracking the performance of the broader S&P 500 index for some years...



...dividend-paying stocks suddenly gained favor last August, quickly leaving the rest of the market in the dust.



Will this trend continue, though? There are at least a couple of reasons to worry that it won't.

For one thing, long-term trends tend to "revert to the mean." This suggests that if dividend-paying stocks are performing strongly today, this could be a foreshadowing of their underperformance tomorrow. Indeed, the recent success of the sector had Barron's itself lamenting earlier this year that the yields on dividend payers had become "stingy."

That's not surprising. With Treasuries paying near historic low yields lately, stocks haven't really had to pay much in the way of dividends in order to look generous by comparison. Indeed, the average yield on the S&P 500 today is a miserly 2%. But one reason for this apparent stinginess derives from how yields are calculated in the first place.

You're Ruining It for Everyone Else!

Consider the case of (imaginary) Pennsylvanian margarine-substitutes researcher Monongahela Original Oleo Laboratories Amalgamated (Ticker: MOOLA). The stock trades for $10 a share and pays a $1 annual dividend -- hence a 10% yield on its stock price.

But what happens if investors suddenly decide that they like this generous yield, and flock to the stock? They bid up the price, and before you know it, Monongahela is selling for $20 a share (a 5% dividend), then $30 (3.3%), and maybe even $40 (2.5%).

Pretty soon, Monongahela's dividend yield is looking as stingy as everyone else on the S&P -- and absent any improvement in earnings, its stock price is looking pretty overvalued as well.

That could be what's happening to dividend stocks today.

Here Be Dragons

Compounding the risk that dividend stocks have become overpopular and overvalued is the potential for government action that could make these stocks very unpopular, virtually overnight.

Currently, many dividends qualify for a reduced tax rate of 15%. But next year, if Congress doesn't take action, dividends will lose their preferential treatment and instead be treated as ordinary income. In Washington, President Barack Obama is said to be floating plans to allow that tax break to expire, in which case rates on dividend payouts could rise as high as the new top personal tax bracket of 39.6%.

When you combine this new tax treatment with phased-out deductions and exemptions for high-income taxpayers, and add the 3.8% tax surcharge passed to help fund Obama's health-care law, experts say the effective rate on dividend income could soar as high as 44.8% -- or three times the current rate.

Congress might restore the dividend tax break beyond the end of this year, of course. But with our national debt hitting new highs daily, Congress must find funds somewhere to finance its spending. And tweaking the formula for how dividends are treated is less likely to raise a ruckus among voters than actually raising tax rates.

The time to dump your dividend stocks is before that happens. Afterward, it will already be too late.

Motley Fool contributor Rich Smith does not own shares of any companies named above.

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Ronsfishinglures

Every one in the real world knows that the China Yen will be the global money in the next 3 years, the USA buck will be out, and on the back burner for the next 100 or so years. This will knock the all mighty buck all the way down to almost nothing in spending power. This is our goverments plan to deflate the mass debt we have and the only way to do it, look up how much we will be paying only in interest cost for the next 25 years, its a few trillion bucks, and that isn,t what we will be paying on the loans itself. The USA is just like all of the Americans that ran up credit cards and paying only the minimum balance and interest each month and NEVER getting the amout payed off, or comming even close. With all the interest we are paying we are making other countrys stronger and there money worth much more, as we become weaker. If people have long term investments and they think they will get a good return it will not happen, when the USA buck falls from grace to China Yen all long term investments will loose tons of value, a lot of pensions will go almost broke, Many states are adopting a back up money system its legal, the mighty buck falling is in the wind. Don,t be cought on the short end of the stick with a pension and stocks that you belive will pay you 3/4 million on retirement when they will ony pay a couple hundread grand for a life time of investing. A few hundread grand is not crap if you want to retire in a good sound way in the next 3 years.

March 18 2012 at 9:56 PM Report abuse rate up rate down Reply
tomgold125

It's time to dump Obama.

March 18 2012 at 9:30 PM Report abuse +1 rate up rate down Reply
myrtlebeachsobol

Did the person who wrote this article actually look to see what GE is paying these days? Not sure you can believe anyone who thinks GE is a top dividend payer.

March 18 2012 at 8:35 PM Report abuse +2 rate up rate down Reply
myrtlebeachsobol

Did the person who wrote this article actually look to see what GE is paying these days? Not sure you can believe anyone who thinks GE is a top dividend payer.

March 18 2012 at 7:42 PM Report abuse +2 rate up rate down Reply
myrtlebeachsobol

Did the person who wrote this article actually look to see what GE is paying these days? Not sure you can believe anyone who thinks GE is a top dividend payer.

March 18 2012 at 7:41 PM Report abuse +2 rate up rate down Reply
me3jewels

Sell your dividend paying stocks and dp what? Put the money into CD's. DUH!

March 18 2012 at 7:30 PM Report abuse rate up rate down Reply
1 reply to me3jewels's comment
jdykbpl45

Obama's new math. Have union teachers make the public dumb. Then have Bernake print more money.

March 21 2012 at 11:34 AM Report abuse +1 rate up rate down Reply
Harry Piels

Seems like the best play might be to dump some of your dividend stocks and short whatever you can. This market looks overbought to this cowboy.

March 18 2012 at 6:28 PM Report abuse +2 rate up rate down Reply
FromTheChrysalis

Recovery? Dubya changed three of the six ways UE is measured, effectively dropping our reported UE rates by 50%. So double the reported rate of 8.3% to get the true rate of 16.6%. When Nobama knocks that down by 50% we'll know for sure that this 12 year Depression is ending.

March 18 2012 at 6:04 PM Report abuse -1 rate up rate down Reply
aviatorta

BUY BABY BUY! THIS MARKET IS GOING TO LEAD THE RECOVERY AND WILL PROFIT ALL WHO CAN AFFORD TO CASH-IN ON THE BULL MARKET. NO DOWNTURN IN SIGHT. SPEND BABY SPENT . BUY ALL THOSE DIVIDEND STOCKS ESPECIALLY GE.. OBAMA WILL BE RE-ELECTED AND HE WILL LEAD THIS COUNTY INTO THE LARGEST MARKET RECOVERY OF ALL TIMES. JUST ASK ANY MEMBER OF THE TEAMSTERS, AFL/CIO AND THE SERVICE EMPLOYEES INTERNATIONAL UNION. ALL THEIR PENSIONS DEPEND UPON IT.

March 18 2012 at 5:01 PM Report abuse -2 rate up rate down Reply
Vern

The article says that if the stock you own doubles or triples in value, it's a disaster! Wow!

March 18 2012 at 3:28 PM Report abuse -1 rate up rate down Reply