The election night parties were barely over last week before investors started selling stocks. While renewed uncertainty over Europe did not help, the source of the volatility was closer to home: The fiscal cliff. Washington now has seven weeks to reach a compromise — a failure to do so will mean the largest fiscal drag in the post-World War II period and a possible recession.

Many investors are particularly worried that dividend stocks are vulnerable given the potential for a near tripling of the tax on dividends. As I’ve said in previous blogs, I believe volatility will remain elevated and stocks will stay under pressure until the president and Congress produce a credible road map to a compromise. That said I don’t believe dividend stocks — with one exception — are any more vulnerable than the broader market. Here’s why:

  1. Many dividend stocks are held in non-taxable accounts. Whether held by institutional investors or by individuals in tax-deferred retirement accounts, a change in the dividend tax rate will have no immediate impact on holders of these securities.
  2. Historically, when dividend tax rates have risen, companies have made investors whole on an after-tax basis by raising their dividends to offset the higher tax rate. Given  that US corporate balance sheets are generally very healthy with S&P 500 companies sitting on more than $2 trillion in cash, and payout ratios are close to historic lows, companies appear to have the wherewithal to increase dividends should taxes rise.
  3. Many high dividend payers are concentrated in defensive industries, like healthcare and consumer staples. These companies tend to be less economically sensitive than other industries. As a result, they typically outperform when the economy is under threat because they’re less vulnerable to a fall in earnings than more cyclical companies.

While I’m comfortable with dividend paying stocks in general, there is one major exception: US utilities. Prior to the Bush tax cuts in 2003, utility stocks typically traded at a significant discount to other segments of the market. This made sense because utilities are a slow-growing, regulated industry. However, since the inception of the Bush tax cuts the sector has been growing progressively more expensive relative to other segments of the market. Today, US utility companies are trading at a slight premium to the broader market. Should the preferential rate on dividends expire, I believe the utility sector may be uniquely vulnerable because it is likely to suffer significant multiple compression.

Over the next seven weeks, investors will need to spend a disproportionate amount of time handicapping the odds of going over the fiscal cliff. If the tax hikes and spending cuts hit, and they are allowed to remain in place for any length of time, I believe that the United States is vulnerable to another recession. Under this scenario stocks will come under significant pressure. However, in the event of another recession, the tax rate on dividends may be the least of an investor’s worries. Dividend stocks will be hit, but probably no worse than the rest of the market. If anything, a defensive tilt – ex-utilities – is probably a reasonable place to hide.

iShares Dow Jones Select Dividend Index Fund (NYSEArca: DVY)