Dividend stocks look expensive – what should you do about it?

We've been fans of blue-chip, dividend-paying, high quality' stocks for many years now.

These companies have a lot going for them: they are tough enough to stand up to most economic conditions, and at a time when interest rates are at record lows, they represent one of the few ways to get an inflation-beating income as long as you're prepared to take the risk of owning stocks.

Trouble is, everyone has caught on to this idea by now. Safe' stocks have outperformed all comers during the bull run of recent years. In some cases, they now look expensive compared to other sectors.

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So what should you do about it?

Investors are willing to cough up for quality

As James Mackintosh points out in this morning's FT, investors are increasingly willing to pay a premium for stocks that pay high dividends. "So much so that they are starting to look dangerously overvalued, especially in the US."

According to JP Morgan Asset Management, the highest-yielding stocks in the S&P 500 now trade on an average of 16 times forward earnings. That's higher than at any point since 1994. The wider market is on about 14.

Reliable dividend payers ones who keep delivering the goods, year-in, year-out trade on even higher price/earnings ratios, notes Mackintosh.

Of course, it makes perfect sense that relatively dull, high-yielding stocks have done well compared to other stocks. If investors are gradually plucking up the courage to stick more money into equities, then where's it going to go first? It's going to go to the safest', most bond-like stocks.

But what do you do when the safe' stocks get expensive?

Don't sell this could go on for a while yet

The first thing I'd say is don't panic and sell.

The key with income stocks as with any asset is to remember why you bought them in the first place. In this case, you most likely bought these stocks because they were paying a decent dividend. Capital gains were a secondary consideration.

So it's the dividend that matters. Unless something happens to affect that the dividend is cut, or cancelled then I don't see any reason to sell urgently.

Also, while I can understand the argument that dividend-payers look expensive, I'm not sure that's going to change in the near future.

If the economy weakens, profits might drop, and dividends might be cut. But this would also be bad for other, more vulnerable stocks. Interest rates would also stay low in such a scenario, meaning that the rationale for buying income stocks wouldn't go away.

If the economy strengthens, interest rates might start to rise. That would make high-yielding stocks less attractive. But a stronger economy would be good for decent companies in the long run, while the threat of rising interest rates would again hit highly indebted, dash-for-trash' stocks hard.

There could be a stock market crash, no argument there. In that case, defensive income stocks would fall. But they'd probably take less damage than their less defensive peers.

The one big danger that my colleague Merryn Somerset Webb worries a lot about, is a change in government tax policy. If governments decide that companies should be investing rather than paying dividends, or that dividends should be taxed more aggressively, that would be bad.

It's not out of the question. But it's one of those nebulous risks that you should be aware of, without necessarily adjusting your entire portfolio.

So as far as I can see, the biggest risk is that quality' stocks might underperform their more cyclical peers if money printing continues but the economy doesn't get a lot worse. In other words, quality' will go up, but just not by as much as other stocks. That's a risk I feel I can live with.

The beauty of rebalancing

That said, you know that we don't like buying assets when they're expensive. At MoneyWeek, we're great believers in mean reversion'. Expensive stuff will eventually get cheap; cheap stuff will eventually get expensive. So if you buy when an asset is expensive, you're more than likely to lose money in the long run.

The big threat here is that investors are currently willing to pay a premium for income stocks. That will change one day maybe not today, maybe not tomorrow, but it will change.

So here's what I'd suggest: take a look at your portfolio (this is all the investment assets you own). If you've never done this before, then I suggest you sign up for our MoneyWeek Basics email, which will explain the basics of asset allocation and rebalancing.

In short, asset allocation is all about making sure you don't have too many of your eggs in one basket when you start building your portfolio. And rebalancing is about making sure it stays that way you check regularly to make sure that your investments haven't become too dependent on one asset class.

Focus on the equity portion of your portfolio in particular. Split the equity portion into stocks or funds you bought for income, and ones you bought for growth.

Now I'm not going to tell you what proportion of your money should be in income stocks as compared to growth' stocks. That's very much up to you and depends on your individual needs.

But let's say you think the balance is starting to look rather skewed. Rather than selling some of your dividend stocks, consider putting some of the income they generate into other segments of your portfolio, rather than reinvesting it back into the same stocks.

You might want to use the money to add to the cheap markets we like: such as Japan, or Europe. Alternatively, you might want to top up the cash section of your portfolio, and sit on the money until you see an opportunity you like.

Or you could just be a bit more selective about the high-yield stocks you buy: focus mainly on those that still offer yields that are above the market average. If you're looking for a good source of information on promising income stocks, you should take a look at my colleague Stephen Bland's Dividend Letter newsletter. Stephen focuses on finding high-yielding, reliable dividend payers, and doesn't worry too much about what's happening to the rest of the market. It's a strategy that has served him and his readers well in recent years.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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