Dividend funds: caveat emptor!

Market Indicators Remain Positive

With the US S&P 500 stock index hitting new highs, we might ask ourselves if shares are finally starting to become expensive, and vulnerable to a near-term correction. Checking a number of my favourite market indicators, conditions look to remain favourable for stocks and shares. 

1. US advance-decline indicator hits new highs

The cumulative advance-decline indicator, that measures how many stocks have gone up versus those that have gone down each day and adds the up-down balance up over time, continues to make new highs. This points to good market breadth, i.e. that the market is being driven by a large number of stocks rising. If this were not to reflect a similar pattern to that for the benchmark stock indices, then I would be concerned. But no worries here...

US Advance-Decline Index Remains very Bullish

 2. US Value Line Geometric Index Also Very Strong

A second measure of market breadth is the Value Line index, which looks at the performance of the average stock in the US. Again, if this were not to be making new highs at the same time as the benchmark stock indices, I would be concerned. But once again, things look good...

US Value Line Index Also In A Bull Trend

3. European Industrial, Bank Stocks Still Performing Well

In an economic recovery scenario, both industrial and financial stocks should perform well, reflecting the benefit of a stronger underlying economy for profits in both these cyclical sectors. Looking below, we can see that European Industrial (SXNP) and Bank (SX7P) sectors are still in strong uptrends, and close to new highs. 

European Industrials, Banks Close to New Highs

But High Quality Dividend Stocks Now Expensive In the US

Interestingly, stable dividend stocks have in particular started to become expensive as investors have looked for yields outside of the traditional bonds and cash sources, given the very low rates of interest currently on offer from both asset classes. 

US Dividend Aristocrat Dividend Yield at record low

The chart above represents the US dividend aristocrat ETF, which only holds US large-cap companies that have raised their annual dividend consistently each year over the last 25+ years. Members include healthcare companies like Johnson & Johnson, and consumer staple companies like Coca-Cola.  All very high quality companies, but now increasingly expensive, only offering a 1.8% dividend yield now as opposed to nearly 2.5% at mid-year. Clearly investors are looking for a better yield than they can get on bonds or cash, but without taking big risks and thus preferring to invest in companies that offer relative stability. 

Focus more on Small-Cap stocks

October has been a pretty good month for Small-Cap stocks, with both UK and US small-cap indices continuing to outperform the large-cap benchmarks and rising in a strong, steady pattern. Both small-cap indices have gained nearly 5% over the last month, continuing to forge new all-time highs. 

UK, US Small-Cap Indices In Steady Uptrend

Favour Industrials, Small-caps; Beware Overvalued Dividends

I remain a big fan of ETFs exposed to small-cap stocks such as the iShares MSCI UK Small-Cap ETF (CUKS) and the iShares S&P Small-Cap 600 ETF (ISP6). You could get exposure to Small-Cap stocks in Europe overall via the db x-trackers MSCI Europe Small-Cap ETF (XXSC). With capital expenditure trends improving, European Industrials also remain a good area for investment at this moment: db x-trackers STOXX 600 Industrial Goods ETF (XSNR). 

But I would be wary of continuing to chase large-cap dividend stocks and indices higher at this point, as many of these stable growth stocks are now sitting at relatively expensive valuations, particularly in the US.  

If you want to buy exposure to European dividends, it would perhaps be better to look at a high-yielding sector ETF that is performing well, such as the STOXX Europe Telecoms ETF (offered by db x-trackers, Lyxor amongst others) rather than chasing what seems to me to be expensive dividend growth, at this point.