How to Replace Lost Dividend Income

• By Simon Maierhofer
• On 12:03 pm EST, Wednesday November 4, 2009

Psst, did you hear that dividend yields are close to an all-time low? Unless you are a dividend aficionado or dependent on dividend income, odds are you didn't.

The major indexes such as the S&P 500 (SNP: ^GSPC), Dow Jones (DJI: ^DJI) and Nasdaq (Nasdaq: ^IXIC) have rallied more than 60%, so who cares about a few measly dividend dollars?

Even though dwindling yields may not be a big issue now, it will be soon. Aside from the economic repercussions of a low yields environment (more about that later), many need to find ways to replace their lost dividend income.

This article will reveal the importance of dividend yields for the economy and the stock market, and offer some suggestions on how to replace lost yields.

Surveying the damage

For the first time since the Standard and Poor's began collecting dividend data in 1955, dividend cuts have outnumbered increases in 2009. If you'd like to put a number on the total of lost income to shareholders, it would be north of $80 billion a year.

Even though financial stocks were first to cut dividends, no sector was spared. Some of the 'casualties' included Macy's, Dow Chemical, Pfizer, Microsoft, Citigroup, and many others.

Dividend yields and stock prices

Dividend yields are measured as a percentage of a company's price and are thus created by the interaction between dividend payout and stock prices.

Generally speaking, lower stock prices result in higher dividend yields, while higher prices create lower yields. Take for example company A, which trades at $100/share and pays a dividend of $2 per share. The dividend yield is 2%. If company A's stock price drops to $50, the dividend yield would spike to 4%, assuming that the dividend payout remains the same.

Naturally then, dividend yields are higher at market bottoms than they are at market tops.

More risk - more dividends

Around the March lows, many ETFs such as the PowerShares Financial Preferred Portfolio (NYSEArca: PGF - News), iShares S&P U.S. Preferred Stock Fund (NYSEArca:PFF - News), and iShares FTSE NAREIT Retail (NYSEArca: RTL - News) spotted yields of 10% and more.

Others, such as the Financial Select Sector SPDRs (NYSEArca: XLF - News), iShares DJ Select Dividend Fund (NYSEArca: DVY - News), SPDR Dividend Fund (NYSEArca: SDY - News), and Vanguard High Dividend ETF (NYSEArca: VYM - News) came with dividend yields between 5% - 8%.

Even though most investors don't directly associate risk with dividends, over the past couple of years, the riskiest sectors - financials and real estate - have been paying the biggest dividends. This correlation can be both painful and profitable.

Painful and profitable dividend investing

Here is an example of profitable dividend investing: After predicting a market bottom below Dow (NYSEArca: DIA - News) 6,700, the ETF Profit Strategy Newsletter sent out a Trend Change Alert on March 2nd. The alert included several strategies to benefit from, what was expected to be, the biggest rally in years.

Regarding dividend ETFs, the newsletter said the following: 'Dividend ETFs with a higher allocation to financials are likely to rise higher than the broad market. There are two things to keep in mind: 1) dividend yields will go down over the next few months 2) the ETFs with the highest yields are likely to be the most volatile.'

Dividend ETFs with an above average allocation to financials did indeed outperform the broad market. PGF gained more than 200%, while others more than doubled. Additionally, investors enjoyed double-digit dividend gains. A win-win situation.

Here is an example of painful dividend investing: On December 18th, 2008, the ETF Profit Strategy Newsletter stated the following: 'Risk management is more important than dividend yield. If history is a guide, dividend ETFs will not be able to protect investors as the stock market slides further.'

Following this statement, the S&P 500 (NYSEArca: SPY - News) and other broad market indexes lost 30% in 90 days. High yield dividend ETFs dropped even harder until the carnage was halted courtesy of the March lows.

How to replace dividend income

Over the past few years, the actual dividends paid by corporations have been eclipsed by the capital gains, or losses of the underlying investment. How good is a 2%, 3%, 4%, 5% annual dividend check if the issuing company's stock plunged 30% - 50% (October 2007 - March 2009)? Or, who concentrates on a 2%, 3%, 4%, 5% dividend check if the issuing company has rallied more than 60% (March - October 2009)?

As the chart below shows, the most important lesson to be learned from recent history is that growth and risk management are as important, if not more important, than dividend yields. A fixation purely on dividend yields will likely prove short-sighted and disappointing for your portfolio's performance. 

Prepare for lower prices and higher yields

Today's investing environment is reminiscent of the scenes in October 2007 and January 2009. Investors are feeling good about owning stocks, economists believe the recession is over, and Wall Street bonuses are expected to surpass all prior highs.

Courtesy of a seven-month rally (rising prices) and dividend pay cuts, dividend yields have once again fallen to a level indicative of a market top, that's right, top not bottom.

Savvy investors tend to take such opportunities to add short ETFs such as the Short S&P 500 ProShares (NYSEArca: SH - News), Short Dow Jones ProShares (NYSEArca: DOG - News), UltraShort S&P 500 ProShares (NYSEArca: SDS - News), or other ETFs that benefit in a down market.

Dividend yields and the stock market

When dividend yields reached an all-time low in 1999, the stock market, in particular the Nasdaq and tech stocks, were close to their all-time highs. When dividend yields reached a secondary low in 2007, the overall market had reached the end of its rope and declined viciously, thereafter. With rising prices and never before seen dividend cuts, dividend yields have now reached another secondary low. Guess what's next.

Whatever little yields you may find at this time will be wiped out by the upcoming decline. Going for yield and regular dividend income now, is like racking up credit card charges just to collect miles - the cost is not worth the benefits.

Because a valuation reset at major market bottoms results in rock-bottom prices, dividend yields at every historic market bottom have clocked in at extremely elevated levels. No bear market bottom is intact unless valuations get reset. No such reset occurred in 2002, nor earlier this year in March, and certainly not today.

Even though you might be dependent on regular income, it would be more advisable to dip into principal (or grow your money with short ETFs) than allow the market to do the 'dipping' for you.

Based on current dividend yields and P/E ratios, compared to historical averages and extremes seen at major market bottoms, stocks have a long way to go before a bottom is reached. Based on the only real valuation, the Dow has already declined 80% from it's high (of course this is not the Dow measured in U.S. dollars).

The November issue of theETF Profit Strategy Newsletter includes a detailed analysis of dividend yields, P/E ratios, and two other trusted indicators and their 'crystal-ball like properties' for the market.

By the time the investing crowd realizes that new lows are on the horizon, it will be too late. You however might be one of the few able to say, 'psst, I got out just in time!'

Buzz up!