06/14/2011 12:03 EDT | Updated 08/14/2011 05:12 EDT

Time for U.S. Dividends

Given the back-sliding in North American equities over the past five weeks, many investors have become concerned that this is, in fact, the start of the so-called "sell in May and go away" phenomenon.

Given the back-sliding in North American equities over the past five weeks, many investors have become concerned that this is, in fact, the start of the so-called "sell in May and go away" phenomenon.

There has definitely been an exodus of momentum from the market and, unlike the sharp erosion back in February and March, this latest grind lower seems to have a broader fundamental base to it. In other words, question marks are once again being thrown up on the state of the U.S. economy, which directly affects Canada as well. At the time of writing, the S&P500 was about 35 points away from the intraday low in March of 1249. The TSX has now twice come close to re-testing its March intraday low of 13,238 as it fails to find any appreciable support from the recent recovery in oil and gold prices.

The natural tendency is to shift out of equities and into cash or fixed income; however, there have been some painful memories over the past two years of hoarding too much of the green stuff, while traditional fixed income investments (CDs, GICs, and solid-quality / reasonable maturity bonds) offer little incentive. This is especially true following the latest rally in bonds.

Assuming that an investor is either neutral weighted equities versus his or her tolerance threshold, or is even underweight, the better option is simply to transition some of the equity portfolio into more defensive names, better value names or those with decent dividend yields and equally pleasing dividend growth rates. If you can nail two or three of the above parameters, then all the better. Given that Canadian investors en masse are still woefully underweight the U.S. market, despite the buying power of a strong Loonie, I'll focus this discussion on those U.S. stocks that might fit the bill.

As with any attempt to hand-pick individual equities, one needs to have some rules. Since we're focusing on dividends in this exercise, we want to make sure that a company is paying a yield higher than the average (in this case the average of the S&P500) and it is growing its dividends. Preferably, we want to see positive growth over five years. We also want decent market cap and P/E ratios that are not out of line with the overall market. Lastly, we want stocks that are exhibiting historical volatility that is less than market. If we run this sort of analysis, a number of companies do stand out that fit these criteria and are also in more defensive sectors of the market.

In the case of the S&P500, the minimum dividend yield we want has to be above 2.5 per cent (or the average), and we'd like to keep P/E ratios around 15. Utilities will tend to dominate a short-list of stocks that fit these measures, but there are some other decent candidates as well, such as AT&T. The stock currently has a dividend yield of over 5.5 per cent, with a 5 per cent growth rate in its dividend. Its P/E ratio is just under the S&P average, while volatilities are well below. On the health care side, Eli Lilly is almost in the top-10, with a dividend yield of 5.2 per cent and growth of close to 5 per cent. But this is more of a value play, considering a P/E of less than 8 per cent. This has definitely not been an exciting stock to watch since the market bottom of 2009, but investors are getting paid to play and that's important. The only other health care stock that comes close to this yield is Bristol-Meyer with a yield of 4.7 per cent, but growth is weaker and it has a higher P/E of around 11per cent.

As I mentioned, utilities make up the lion's share of the list with nine of the top 20 spots in terms of dividend yield. This includes names like Integrys Energy, Progress Energy, FirstEnergy, Exelon Corp and PPL Corporation. The one thing to be careful about with the utilities is that these will tend to be more interest-rate sensitive and therefore more vulnerable to a back-up in interest rates. It is inevitable that this will happen -- we just don't know when the major move in rates will start. Pundits have been calling for this move for so long now it's almost like a badly directed version of Waiting for Godot, and the economic headwinds facing the U.S. and still overwhelming debt loads will impart a low altitude cap on rates over the medium-term.

Still, with the five year Treasury yield sitting down near 1-1/2 per cent, the allure of dividend stocks has only grown, and utilities should still be considered. The only sector I would probably avoid would be consumer discretionaries and possibly even some of the industrials, on the assumption that the U.S. dollar could still experience a knee-jerk bounce and cause profitability for exporters to wane.