By now you know that we have started to become cautious on some of the top dividend stocks.  It is not that we think anything is wrong at the companies, and it is not that the companies cannot grow their dividends some ahead.  The problem is that these defensive stocks with high dividends have reached a point where they are trading at too high of a market premium even if interest rates are extremely low. We have already sounded the dividend bubble warning.

What do you do when the iShares ETF group warns that utilities are looking like they are trading too expensively?  This group has decades worth of data to analyze and this week the iShares blog claims that they are just trading at too high of multiples compared to their history and compared to the broad market.  One concern is that utilities are less profitable on a relative basis than in the past.  It turns out that the cheap borrowing costs are being offset by regulatory and decommissioning costs. Here is the iShares warning: “Since 1995, US utilities have traded at an average discount of roughly 25% to the S&P 500. Today, however, US utilities are currently trading at a more than 8% premium, the largest since late 2007.”

When we warned you last week about the growth of the dividend bubble, we already told you that utilities were the single best performing sector in the S&P 500 Index (NYSEMKT: SPY) in 2011 and that they were up this year too.  There is nothing wrong with the utility sector, save a nosebleed valuation.

The reason investors are chasing this sector is simple: high dividends!

The Utilities Select Sector SPDR (NYSEMKT: XLU) trades with a dividend yield of about 3.78% according to Yahoo! Finance.  At $37.13, the 52-week range is $29.45 to $37.78. The Southern Company (NYSE: SO) is up 0.6% at $47.40 today and its yield is 4.1%.  Exelon Corporation (NYSE: EXC) is down 0.5% at $38.67 and its yield is 3.9%. American Electric Power Co., Inc. (NYSE: AEP) is up two-cents at $41.46 and it still yields 4.5%.

Before you hit that panic-sell button upon seeing the term ‘bubble’ here, this only matters to new buyers today.  If you have been reading 24/7 Wall St. for long, you know we have been huge fans of dividends and of utilities. Maybe this is a good time to start selling out-of-the-money covered calls.  We still are fans of certain utilities, but we would like to see a pullback of 7% to 10% before revisiting this sector.

JON C. OGG

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