Beware the Roaring Twenties

Income Investing

Beware the Roaring Twenties

For the first time in years, valuations -- not black swans or politics or the Fed -- are a challenge.

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It’s the new Roaring Twenties, so let’s call up an authentic voice from the last such era: Thorstein Veblen, an economist and social critic who coined the phrase “conspicuous consumption.” Veblen’s most enduring observation is that the more something costs, the likelier wealthy people or status-seekers are to buy it. Economists call such baubles Veblen goods. And today they seem to be plentiful in many investors’ income portfolios.

See Also: 30 Massive Dividend Increases From the Past Year

Stocks are expensive, bond prices appear gold-plated, and real estate investment trusts just finished their best year since 2006. Gold is on a roll. The case for caution is legitimate.

Then again, the excesses of the 1920s—and other bull runs, such as those in the 1980s and 2010s—went on and on, frustrating killjoys and permabears. I’ve advocated that everyone stick with what’s working, choose higher-yielding investments over lower-yielding ones, reinvest returned cash and new money, and ignore short-term, news-driven setbacks. That’s paid off.

But I don’t know how much the market will keep bidding up the price for each dollar of interest or dividends. Is there a breaking point? And is it in sight? In 2019, the strategists and portfolio managers all told me that low inflation, falling interest rates and a compliant Federal Reserve have built a concrete floor under share prices. Buyers might hesitate, but mass selling is not in the offing.

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However, I find that many heretofore reasonably priced dividend stocks and other investments really are rich. It’s sensible now to look over your holdings and see if you have something that appears to be vulnerable at its current price. The following isn’t a strict sell list, because if you have large embedded gains, you can better afford a correction than a capital gains tax bill. Dividends and most interest payments are not in danger. But I expect some sharp price setbacks. Here’s where I see some red flags:

AT&T. A year ago, people piled into the only bona fide blue-chip common stock with a yield above 7%. Then, you paid roughly $14 for each $1 of T dividends. Now, with AT&T (symbol T) pushing $40, the price per dollar of dividends is nearly $20. That’s steep.

Baby bonds with $25 par value trading for $27. Discounts have become scarce among these low-face-value IOUs. Never mind that the interest rate climate is more bullish now that the Fed has stopped tightening. That’s a high markup to pay for these bond snippets.

Dividend funds. The sobriquet dividend on a fund or a strategy can disguise some awfully high valuations. The 10 largest holdings of iShares Select Dividend ETF (DVY) boast a 43% one-year average return. But of those 10, only one, Dominion Energy (D) , declared much of a dividend hike in 2019.

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Certain closed-end funds. Gabelli Utility Trust (GUT) has an average long-term return for a utility fund and a portfolio full of the usual suspects. Yet it commands a premium to net asset value of 57%? Even Jay Gatsby wouldn’t pay that—but somehow, someone is.

Water utilities. For years, American Water Works (AWK) and Aqua America (WTR) had price-earnings ratios in the 20s and sharply rising dividends. Now the dividend growth has slowed, and you pay over 30 times earnings for both American and Aqua. Clean water is priceless, but these shares shouldn’t make Apple look cheap.

I’m not bearish on the economy. But for the first time in years, valuations—not black swans or politics or the Fed—are a challenge. Even if investment excesses aren’t wretched, they still have a way of correcting. So, shop carefully, review what you own, and don’t chase the herd.

See Also: Pros’ Picks: The 13 Best Dividend Stocks for 2020