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Are Dividend Stocks Being Over-Hyped?

As MoneyWatch's Eric Schurenberg recently reported, dividend-paying stocks emerged as a rare bright spot among much manager gloom at last month's Morningstar Investment Conference. And the chorus singing dividend payers' praises is not confined to stock managers pushing their book. Glass-half-empty market watcher James Grant recently talked up dividend stocks, labeling a list of intriguing dividend plays "Treasury alternatives." (The list is in Schurenberg's post linked above) while David Rosenberg, the well-respected bear at Gluskin Sheff noted yesterday that dividend payers are "bonds in drag." (That was a compliment.)

What's with all the sudden dividend love? Well, The 2 percent yield on the S&P 500 index is more than the payout on a five-year Treasury, and its not hard to find deep-blue blue chips, such as Johnson & Johnson (JNG; 3.6 percent yield) generating more income than the 3 percent yield on a 10-year Treasury. Moreover, stocks can actually do just fine in a rising rate environment, and as Morningstar recently laid out plenty of top-quality blue chips with a competitive edge not only have compelling dividend payouts but are also trading at below-market valuations.

So are dividend payers really all that? And more importantly, are bonds the worst idea right now?

How to Put Dividends to Work in Your Portfolio
The wrong interpretation of all the dividend hype is that it is a call to completely bail on bonds. This isn't meant as a bake-off between the two. Bonds are bonds, stocks are stocks. Different risk profiles, different roles in your portfolio. No one is suggesting you dump bonds for dividend stocks.

"I don't want to tell people don't buy bonds. That's not fair," veteran dividend-ace Hersh Cohen recently told MoneyWatch. "What I think you have to weigh is what are the most attractive asset classes and shift assets in that direction," said Clearbridge's chief investment officer.

But for the past 18 months investors have been shifting the wrong way, pouring record amounts into the bid-up Treasury market and shunning equities, including many well-priced dividend stocks. At the very least you want to get back to your long-term stock/bond mix. Then, while you're at it, take a look at dividend-payers for a piece of the equity stake. And as Cohen notes, maybe now is a time for a tactical shift (translation: small, not large) to give dividend stocks a bigger play in your overall portfolio if you are comfortable with stock-market volatility.

That's not just a market timing gambit. What's nice about the recent spotlight on dividend stocks is that it's making a case for one of the best time-tested investing strategies. Dividend stocks, especially those that have a likelihood to increase over time, are anything but a short-term story. Just take a look at this chart compiled by Ned Davis research that covers six recessions and two massive bear markets.

Source: ThomasPartners

That said, investing in individual dividend-payers comes with the obvious risk of any direct investment: it can blow up on you. BP's recent move to suspend its dividend is just the latest instance of a disappearing dividend; and 2008 was the worst year on record for dividend cuts. Sticking with a diversified fund or ETF is a smart way to reduce the risk of being smacked hard by an intermittent dividend blow-up. The SPDR S&P Dividend (SDY, 3.7 percent yield) is an ETF worth a look. Among funds, Vanguard Dividend Growth (VDIGX 2.3 percent yield) focuses on companies likely to increase their dividend payout.

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