Buying Dividend Stocks: A Smart Move in an Uncertain Market

We’re now well into 2024, and the outlook for stocks and bonds vacillates daily based on economic news, Fedspeak, and the prospects for interest rates. At the start of the year, investors expected the Federal Reserve to cut interest rates multiple times in 2024, beginning in March. But after several strong pieces of economic data, the Fed has signaled a March cut is unlikely. Investors are repricing stocks and bonds for fewer cuts, starting later.

Rates matter for bond prices, which move inversely to interest rates, as well as for stocks, which are valued based on earnings potential compared with a risk-free Treasury rate. Many pros believe stocks are overvalued and getting more so as rates rise.

Taking this into account, a smart strategy for investors with fresh cash to put to work is to buy dividend stocks. They tend to represent good stock values, and several sectors provide plenty of income while offering equity upside.

Dividend Stocks: A Reliable Source of Income Amidst Rising Interest Rates

Investors often look to the bond market for income, but dividend yields of 3% to 6% are available on a range of stocks in the U.S. and overseas. That’s comparable to bond yields, with most municipal bonds yielding 3.5% or less, Treasuries at about 4%, and high-grade corporate bonds at around 5%.

There’s nothing wrong with bonds, but stocks offer dividend growth and tax advantages. Most U.S. corporate dividends are taxed at a top rate of 23.8%—including a Medicare surcharge of 3.8%. Investors face a higher tax bite for most bond income, except for munis.

Buying Opportunities in Dividend Stocks: Looking Past the Tech Rally

Many investors think they have missed the stock market rally, with the S&P 500 index recently hitting new highs. But the market advance was largely concentrated in the tech sector in 2023, including the Magnificent Seven— Apple, Microsoft, Alphabet, Amazon.com, Nvidia, Meta Platforms and Tesla. That trend has continued into 2024, with shares of Microsoft, Meta, Nvidia, and Alphabet recently hitting record-high prices.

In contrast, most dividend-rich sectors of the stock market have largely sat out the big rally of the past year, including electric utilities, real estate investment trusts, consumer staples, healthcare, banks, and energy. Banks, energy, and utilities, for instance, are actually in the red over the past 12 months.

Rate Cuts and Dividend-Paying Stocks: A Bullish Outlook

Plus, the prospect of rate cuts by the Fed this year—even if not as many as investors hoped for a month ago—looks bullish for dividend-paying stocks. Money-market funds, Treasury bills, and certificates of deposit will offer less competition for stocks if short-term rates fall toward 4% by the end of 2024 from the current 5.35%. That could drive individual investors out of money-market funds, T-bills, and CDs, where they have trillions of dollars parked.

One risk is that a continued strong economy prompts the Fed to move even more cautiously than the markets now anticipate. That could dampen demand for dividend payers, but the negative impact on bonds could be more severe.

Dividend Opportunities Abroad: Seeking Yield Outside the U.S.

There is also plenty of yield outside the U.S., where companies favor dividends over stock buybacks. The broad iShares Core MSCI EAFE ETF, which tracks developed markets outside the U.S., yields about 3%, double the dividend rate on the S&P 500.

Overseas stocks have been lagging behind the S&P 500 for a decade, and the same is true this year. International stocks may have their day—although many pros have wrongly called for such a turn for years. It may take a cooling in the U.S. technology sector for that to happen.

Big U.S. tech stocks dominate the S&P 500 and have driven its gains in the past five years. Tech and related companies account for over 30% of the S&P 500 versus less than 10% for broad international indexes. There are few megacap tech companies outside the U.S. The only tech stocks among the top 20 holdings of the iShares Core MSCI EAFE ETF are ASML and SAP. Thus, buying foreign stocks amounts to a bet that value-oriented stocks will return to favor.

Finding Dividend Opportunities: Sector-Specific Picks

For investors who prefer picking stocks, consider which sectors are most attractive and drill down from there.

For example, electric utility stocks offer a good combination of yield, growth, and safety. The industry’s earnings outlook is the best it has been in decades as companies build renewable power—wind and solar—as well as associated transmission lines to decarbonize and fortify the grid. And the growth in electric vehicles should help boost what has been negligible demand growth.

Another source of yield is energy stocks, which have lagged behind the market in recent months as oil prices have retreated 15% to around $75 a barrel. Industry leader Exxon Mobil yields close to 4%, while Chevron yields 4.5% based on its dividend boost in January. Both stocks trade close to their 52-week lows. Their payouts look secure, and both trade for about 11 times projected 2024 earnings.

Even cheaper are European oil companies like Shell and BP.

Real estate investment trusts are one of the more rate-sensitive sectors of the stock market. The sector cratered in 2022 but gained about 10% in 2023, helped by the late-year rally in the bond market. The big Vanguard Real Estate ETF yields about 4%.

Investors have justifiably favored so-called internet staples such as Alphabet and Amazon.com in the past five years, but there is something to be said for leading consumer-staples stocks including PepsiCo, Coca-Cola, and Procter & Gamble, which have badly lagged behind the market this year.

Of course, a portfolio shouldn’t be all stocks, and you’ll want some bonds for diversification in case the economy takes a turn for the worse. But don’t shun cash, the ultimate safe investment. Short rates may be headed toward 3% over the next few years, but even if that happens, cash isn’t a bad asset class.

Analyst comment

Positive news: Buying Dividend Stocks: A Smart Move in an Uncertain Market
Short analysis: Investing in dividend stocks is a smart strategy for investors with fresh cash. Dividend stocks offer good value and income, especially in sectors that have sat out the recent rally. The prospect of rate cuts by the Fed is bullish for dividend-paying stocks. There are also opportunities for yield outside the U.S., and sector-specific picks like electric utilities, energy stocks, and real estate investment trusts are attractive. Investors should also diversify with bonds and cash.