With the Reserve Bank of Australia all but certain to consider (at the very least) a significant program of interest rate cuts over this year, it is an important time to consider your exposure to dividend-paying shares. If rates are cut, the yields from bonds, cash and fixed-interest investments will fall even further than the inflation-matching levels they are at present.
What is equally concerning is that with lowering interest rates, conventional wisdom suggests this will push asset prices like shares and property to new highs. This is because, according to Warren Buffett, interest rates act like gravity on the stock market (holding everything down). Falling interest rates allow other assets to float a little higher.
The yield from Commonwealth bonds is informally known as the 'risk-free rate' due to the practically negligible risk of default by the Australian Government (the issuer). If the risk-free rate falls due to interest rates being cut, the intrinsic attractiveness of stocks and other riskier income-producing assets rises as they become more necessary to hold in an inflation-beating portfolio.
The impact of rate cuts on ASX dividend shares
It is also important to remember that stock prices today reflect both today and tomorrow. As the market has moved to price in one and then two or more interest rate cuts this year, stable, dividend-paying shares have risen strongly and are now pushing into dangerous pricing territory (in my opinion).
The Coles Group Ltd (ASX: COL) share price, for example, has risen roughly 10% over the past two months. The grocery giant is set to become a solid, stable dividend payer and now trades with a price-to-earnings (P/E) ratio of more than 20x, which I consider very high for a consumer staples stock. Its arch-rival Woolworths Group Ltd (ASX: WOW) is trading with a P/E ratio of more than 26x, which is equally baffling to me as I'm not sure who expects Woolworths to pump out market-beating growth numbers over the next few years.
It gets better. Funeral provider InvoCare Limited (ASX: IVC) shares have risen more than 56% YTD and now trade on a P/E ratio of more than 42x. This is an astonishing figure, as the funeral industry has some of the most predictable growth rates around. Deaths in Australia are predicted to rise by a rate of 3% by 2030 (hardly exciting on any angle) and yet there is a rocket under the InvoCare share price.
Foolish Takeaway
These numbers raise some serious red flags for me as an investor. Consumer staples and services stocks can typically see rises like this at the back end of a bull market as cash-flushed investors seek safety. If you are an income investor, I know that times are tough right now. But it is always important to be careful of what price you are paying for shares and their dividends—high prices don't last forever and if you can afford to be patient, it might pay off.
