Buying dividend stocks now is no slam dunk

Talk is percolating among investors that dividend stocks will be a strong holding in 2025. But that talk omits a major cloud surrounding the stocks – interest rates.

Rates may prove to be higher than expected, which could make bonds and other fixed-income investments more attractive than dividend stocks. The S&P 500 dividend yield stands at 1.2% far below the 10-year Treasury yield of 4.3%.

Many investors expect the Federal Reserve to cut rates at its next meeting Dec. 18, but that’s not a certainty. And even if it does, few, if any, additional rate cuts may be coming. That’s because inflation remains above the central bank’s target and economic growth could stay strong. 

The Fed’s favored inflation indicator registered 2.3% year-on-year in October, above the Fed’s goal of 2%. Meanwhile, the economy grew an annualized 2.8% in the third quarter, and the Atlanta Fed’s forecast model predicts 3.3% for the fourth quarter. 

Stubborn inflation and strong economic growth could push long-term interest rates higher whatever the Fed does to short-term rates. And again, higher interests favor bonds over dividend stocks.

The benefits of dividend stocks

None of this is to say dividend stocks represent a bad investment. One indication of their benefits is that all of Berkshire Hathaway’s (NYSE:BRK.B) 10 biggest stock holdings dole out dividends.

Dividends payers are often strong companies that provide regular income, with the possibility of capital gains. Plenty of dividend payers increase their payout each year too. Utilities, financial services companies and consumer product companies are ones that generally pay dividends.

But keep in mind that dividend stocks are bigger on safety than returns. The S&P 500 Dividend Aristocrats index, which includes companies that have raised their dividends for at least 25 straight years, has generated a total return of 9.96% annualized over the last five years. That doesn’t come close to matching the 15.84% return for the S&P 500 as a whole.

Risks and valuation issues

In addition, not all dividend stocks are safe. Drug giant Pfizer (NYSE: PFE) has generated an annualized loss of 1.96% over the past five-years, including dividends. And telecommunications heavyweight Verizon Communications (NYSE: VZ) lost 2.07%.  

After the broad stock market’s strong rally of the last five years, some dividend stocks may be overvalued. Retailer Costco Wholesale (NASDAQ: COST) trades 84% above research firm Morningstar’s fair value estimate, and equipment maker Caterpillar (NASDAQ: CAT) trades at a 46% premium.

Age could play a role in determining whether you want to buy dividend stocks now. If you’re below 40 and don’t need to sell anytime soon, long-term gains by the stocks could make any sluggishness now irrelevant. Older people looking for dividend stocks may want to wait for valuations to ease before jumping in.

Whether you’re young or old, just keep in mind that the short term outlook for dividend stocks is no slam dunk.