Investors have cheered the central bank easing its position on the economy as the S&P 500 recovered to its highest levels since 2007. Europe seems on the way out of its multi-year debt crisis, China is increasing approvals for stimulus projects and the Federal Reserve is ready to do what it takes to support the U.S. economy.

But despite this year’s almost 10% gain in the S&P500, the index has yet to meet levels reached more than a decade ago. In fact, since March 2000, the index has returned a miserable 1.2% annual gain with dividends. After adjusting for inflation, investors have actually lost an annualized 1.2% during the period.

With this kind of market, it’s no wonder investors rush to the relative safety of high-yielding stocks in defensive sectors. If no one knows where stock prices are going to be tomorrow, then at least it’s possible to pocket 3-4% in the form of dividend income to show for our troubles.

Unfortunately, dividend investing is not immune to the same boom-bust cycles that happen throughout the market, and investors may soon be in for a rude awakening. 

Research by AllianceBernstein recently showed that utilities and consumer staples sectors were trading for valuations more expensive than 90% of the time during the past 30 years and the telecom sector is more costly than it has been more than 80% of the same period. This compares with valuations in the health care, auto and technology sectors, which have only been cheaper 30% of the time in the past three decades.

While dividends have historically represented about half of the total return to the S&P 500, the quarterly dividend payments come out of a company’s earnings, which most likely inhibits its ability to invest and grow. For this reason, high-yielding stocks are usually valued at a lower price-to-earnings (P/E) multiples  than growth stocks. If too many investors pile into dividend-paying stocks and push valuations into growth-stock levels, then there is a good chance that sharp losses will follow when the euphoria subsides.

When a nice yield means nothing
Take Dominion Resources (NYSE: D) for instance. The shares are trading for 15.4 times forward earnings, which is about the 10-year average for P/E ratio, but are priced at a lofty 22 times trailing earnings. This disconnect is clear when you look at revenue, which has been stale during the past few years. It reached $14.3 billion in 2011, a 12% decline from 2008, but has only grown at a compound annual rate of 3.8% in the past decade. For the company to meet earnings growth expectations without significantly improving on its 10-year average net margin of 11%, Dominion would have to grow revenue by 21% next year. Because this company is in such a highly regulated industry, this is something not likely to happen.

Shares of Dominion pay an attractive dividend of 4%, but if the P/E returns to the historic average, then shares could drop 30% to about $37 per share.

Another high-yielding bubble waiting to pop
Verizon Communications (NYSE: VZ) has seen shares shoot up 30% in the past year, but is trading at 45 times trailing earnings compared with its historical average of 23. The telecomm space once sported impressive profitability, with net margins around 10% in 2004. In the past three years, however, competition has whittled profitability down to an average of just 2.6%. 

Telecom companies return most of their free cash to investors in the form of dividends, so they only expect revenue to grow in the single-digits. Investors expect Verizon to almost triple earnings to $2.49 a share for fiscal 2012, after a huge write-down in the fourth quarter last year caused earnings to drop to just 85 cents a share. The problem is, Verizon has had a losing quarter due to write-downs for each of the past three years, so investors cannot ignore the possibility of further losses.

Investors have rushed into the stock because of its nearly 5% dividend yield, but even if Verizon can manage a 50% rebound in earnings, then shares could fall by more than 22% to $35 given historic P/E valuation.

One of two things could ultimately burst the bubble for high-yielding stocks. As growth returns to the rest of the market, investors may realize they no longer need the relative safety of these defensive sectors. The change in sentiment could bring a sharp exodus from these stocks, bringing share prices to return to their historic valuations. Even if investors do not reallocate to growth stocks, earnings expectations are fairly high for these two stocks. The market may reassess valuation in these stocks if these expectations are not met or if forward guidance is weak. 

Risks to Consider: Bubbles tend to inflate over a period of time, and the ultimate burst is impossible to forecast. Share prices of these two stocks could continue to rise and even outperform the general market. While there is a risk of missing out on some gains, the past decade has shown us that the bigger risk is in holding an overvalued stock too long and seeing your profits disappear with the bubble’s burst.

Action to Take–> Dividends are an important part of every portfolio, but investors should avoid paying so much for stocks that eliminate any advantages of dividend gains through sharp share price decline. Avoid higher priced dividend-payers such as the two mentioned above and look for cheaper stocks with stable earnings growth that justifies their valuation.

P.S. — Amy Calistri has developed a portfolio of dividend stocks like these that holds up remarkably well in down markets. For example, in the sell off last year the S&P 500 lost 5.3% in August alone. Despite all the turmoil, Amy’s Daily Paycheck portfolio fell just 1.0% during the month. To learn more about Amy’s strategy — including a few more high-yield picks she likes — you can visit this link to read more.