One consequence of the market’s ongoing rally has been shrinking dividend yields. The Dow Jones U.S. Index (IYY), an exchange-traded fund that tracks the largest 1,200 domestic stocks, yielded just 1.9% at the end of last week. Within the slightly broader S&P Supercomposite 1500 index, just 263 members traded with yields above 3.0%.

I’ll admit that 263 sounds like a number that would still give income-hungry investors plenty of choices, but adding two key filters quickly narrows this list. The first filter is a requirement for dividend growth. Research from Ned Davis Research shows that shares of companies that raise or initiate dividends greatly outperform shares of companies that do not raise their dividends. The second is free cash flow. In order to continue paying and raising a dividend in the future, a company has to generate more cash than it spends.

Merely requiring positive dividend growth cuts the list nearly in half to 133. Requiring dividends to grow faster than the rate of inflation, which is currently at 2% according to the February Consumer Price Index, narrows the list down to 118. (If dividends grow slower than inflation, the purchasing power of the quarterly payments is reduced.) Adding in a requirement for positive free cash flow cuts the list even further, down to 79. A table with all 79 companies is published on AAII.com in the Web edition of this update.

Keep in mind that I have not considered other important factors such as price-earnings ratio or earnings growth. Adding these components would narrow the list of passing stocks even further. You could potentially find a few additional names by analyzing the 26 utility stocks that were eliminated by the free cash requirement, but overlaying valuation would still keep the list restrictive.

Needless to say, if you are someone who seeks dividend income, these are not numbers that will make you smile.

Could you find higher yields? Absolutely, but you are also taking on greater risk to seek income now. High yields are a sign that other investors perceive problems and want a higher yield to be compensated for those risks. In the current market environment, stocks with yields above 4.5% should be analyzed closely. There might be some bargains, but since higher yields imply lower valuations, it is important to remember that some stocks are cheap for a reason.

I would also suggest thinking about total return. Though this can be a tough concept for those of you who adhere to the “take income only and never touch principal” methodology, I will point out that both price appreciation and income contribute to wealth. From the standpoint of investing in equities, you should be indifferent as long as you are realizing long-term gains and qualified dividends. At the end of the day, it is a question of what dollar amount you are able to safely withdraw from your portfolio, not whether those dollars were funded by capital gains or dividend income (assuming, of course, the tax consequences are equal).

Bearish Sentiment Surges

I want to add a quick note about our weekly sentiment survey. Bearish sentiment, expectations that stock prices will fall over the next six months, surged by 26.3 percentage points to 54.5%. This was the third largest one-week increase in pessimism recorded since the survey started in 1987.

The rise also put bearish sentiment at an extraordinarily high level (more than two standard deviations above its historical average). Notably, bullish sentiment is close to being two standard deviations below its historical average, essentially making it extraordinary as well. Though extraordinary readings in our survey have been correlated with market reversals, the correlation is not perfect. In fact, no single indicator is flawless. So, when a market indicator turns bullish or bearish, look at other indicators to increase the odds of being correct.

I personally consider items such as prevailing valuations and the technical strength or weakness of the market when assessing direction, though I’m more focused on my investing process than my market forecast. I’ve found that over time an investor will do well if he adheres to a good long-term strategy as opposed to trying to determine where the market is heading next.

More on AAII.com

• Dividend Safety Signs and Warning Flags – Indicators you can look at to judge the safety of a company’s dividend.
• Chasing Dividend Yield for Income: Three Reasons to Be Wary – Rod Greenshields of Russell Investments explained why only focusing on dividends, instead of total return, can be risky.
• AAII Dividend Investing – We follow a total return approach to managing this portfolio of 24 dividend-paying stocks.
• At What Point Do You View a Stock’s Yield as Being Too High? – Tell us on the AAII Discussion Boards.
• AAII Sentiment Survey – Bearish sentiment surged to 54.5%.
• Don’t forget to take the Sentiment Survey.

• Picking the Right Stocks Using Charts – For those of you looking to take advantage of the market’s current momentum, charts can reveal which stocks have the strongest upward trends.
• The Covered Call: An Income Generating Options Strategy – For those of you who are nervous about the market, covered calls can provide income to partially offset downside risk.
• How Do You Stay Focused on the Long Term? – Tell us on the AAII.com discussion boards.
• Don’t forget to take the Sentiment Survey.

The Week Ahead

I will speak to our Boston Chapter this coming Wednesday, April 17, and to our Connecticut Chapter on Thursday, April 18. Visit our Local Chapters page for information on a meeting near you.

Earnings season will heat up with nearly 70 members of the S&P 500 scheduled to report. Included in this group are Dow components Coca-Cola (KO), Intel (INTC) and Johnson & Johnson (JNJ) on Tuesday; American Express (AXP) and Bank of America (BAC) on Wednesday; International Business Machines (IBM), Microsoft (MSFT), UnitedHealth Group (UNH) and Verizon (VZ) on Thursday; and General Electric (GE) and McDonald’s (MCD) on Friday.

The week’s first economic data will be the April Empire State manufacturing index and the April National Association of Home Builders index, both of which will be released on Monday. Tuesday will feature the March Consumer Price Index (CPI), March housing starts and building permits and March industrial production and capacity utilization. The periodic Beige Book will be published on Wednesday. Thursday will feature the April Philadelphia Federal Reserve Survey.

The Treasury Department will auction $18 billion of five-year inflation-protected securities on Thursday, April 18.

AAII Sentiment Survey

Bearish sentiment, expectations that stock prices will fall over the next six months, spiked upward by 26.3 percentage points to 54.5%. This is the highest pessimism has been since July 8, 2010.

The 19.3 point plunge in bullish sentiment was the largest one-week drop since optimism fell by 17.6 percentage points on November 18, 2010. This week's drop is also the 34th largest in the history of the survey and the 66th largest overall weekly change. The AAII Sentiment Survey started in 1987.

The 26.3 percentage point rise in bearish sentiment was exceeded only by a 26.7 percentage point rise on July 3, 2003 and a 30.0 percentage point rise on March 30, 2000. This week’s change is also the fifth largest in the survey’s history. Pessimism fell by 29.2 percentage points on April 6, 2000, and by 27.3 percentage points on June 26, 2003.

A total of 145 AAII members took the survey this week. This is down from the three-month average of 330 responses. A weekly “reminder” email normally sent to a sample of our members was unintentionally not sent this week. Previous drops in the number of respondents on a given week have not resulted in the magnitude of change recorded in this week’s survey, however. Furthermore, 145 is not an abnormally low number of responses for the survey.

We are not seeing any specific signs that would suggest why pessimism surged and optimism fell so much. The disappointing jobs report could have played a role. We can say that some members have previously expressed concern that stock prices have moved too far, too fast and are now due for a pullback.

At current levels, bearish sentiment is at an extraordinarily high level (more than two standard deviations above its historical average) and bullish sentiment is near an extraordinarily low level. (A bullish sentiment reading below two standard deviations would be 17.9%.) Such readings have historically been a contrarian signal. Though there is a correlation with between extraordinary sentiment readings and market reversals, as is the case with any single market indicator, the correlation is not perfect. Therefore we would consider other indicators and factors before making any judgment on the short-term direction of stock prices.

This week’s special question asked AAII members if the rhetoric from and the actions by North Korea are influencing their short-term outlook for stock prices. More than 80% of respondents said no, the terse language and actions from North Korea are not impacting their sentiment. A few members said it was having some impact, but also noted that other macro factors are also influencing their sentiment toward U.S. stocks.

Here is a sampling of the responses:

• “No. I think most investors assume that North Korea is just making threats to get something of value from the rest of the world.”
• “Not really. I think most people see this as ‘business as usual’ for a new dictator.”
• “Not until an actual armed conflict occurs.”
• “Yes, but biggest issue at present is that this market needs rest.”

Table 1. Dividend Stocks With Yields Above 3% and Positive Free Cash Flow