The Market Is Flashing Warning Signals Not Seen in Years. Here’s Why I Just Bought 3 of SCHD’s Dividend Kings.

The stock market is flashing a warning sign. The Shiller CAPE Ratio is approaching 42, its second-highest reading in 150 years (hit right before the dot-com crash). However, instead of selling stocks and going into cash, I've been buying companies built to survive moments like these.

Three of my recent purchases were Abbott (NYSE:ABT), PepsiCo (NASDAQ:PEP), and Procter & Gamble (NYSE:PG). All three are Dividend Kings (companies with 50 or more years of annual dividend increases) and top holdings of the Schwab U.S. Dividend Equity ETF (NYSEMKT:SCHD). Here's why I think they're ideal stocks to buy at a time when the market is historically overvalued.

Image source: Getty Images.

The warning signal

The Shiller CAPE ratio (cyclically adjusted price-to-earnings ratio) measures whether the stock market is overvalued or undervalued relative to its historical inflation-adjusted earnings record. It just hit its highest level since the dot-com era. That's a bad omen as the S&P 500 (SNPINDEX:^GSPC) lost nearly half its value over the next two-and-a-half years.

Another notable peak came in Oct. 2021 when the Shiller CAPE ratio hit 38.6. That preceded the 2022 rate-driven bear market in stocks.

These three Kings stand out

I'm not predicting that the stock market will crash. However, with the Federal Reserve recently hiking interest rates for the first time in three years, I'm becoming more defensive because stocks have historically declined during rate-hike cycles, as we saw in 2022. Still, I want to maintain upside in the equity market because it has historically recovered quickly following a Fed-induced decline.

That's why I'm adding some defensive ballast to my portfolio by investing in high-quality dividend stocks with durable revenues and strong balance sheets. Abbott, P&G, and PepsiCo all passed my quality screenings.

Abbott owns a diversified portfolio of high-quality healthcare products, including diagnostics, medical devices, nutritionals, and branded generic medicines. Demand for these products tends to be highly resilient and steadily rising. That's evident in its dividend, which Abbott has raised for 54 straight years. The company currently offers an attractive 2.5% yield and trades at a very reasonable 18.5x forward earnings (cheaper than the S&P 500's 19.5x forward earnings multiple). I think there's a clear case that Abbott's stock could more than double over the next decade, given its low valuation and solid earnings growth profile. It has the exact profile I'm seeking. A durable business, attractive and growing dividend, and compelling upside potential.

Procter & Gamble stood out for its collection of resilient household brands, which includes Bounty, Charmin, and Gillette. It's currently facing near-term pricing headwinds that have weighed on its valuation. As a result, it trades at less than 22 times forward earnings, near its lowest valuation over the past five years. That's why it currently offers a nearly 3% dividend yield. P&G has increased its dividend for 70 straight years, showcasing the durability of its business over the decades. I expect P&G to eventually get back to the mid-to-high single-digit annual core earnings growth rate it's targeting over the long term as its margins improve. Add in its strong cash flows and fortress balance sheet, and P&G offers ballast in a more turbulent market, with solid long-term upside potential.

Finally, PepsiCo also benefits from durable demand for its iconic portfolio of beverages and snacks. That has supported 54 years of dividend increases. Like P&G, it's currently facing headwinds that have weighed on its valuation (15x forward earnings). That's why it currently offers a dividend yield of more than 4.5%. That high starting yield provides a meaningful income return.

Meanwhile, PepsiCo doesn't need to grow very fast to deliver strong total returns. If the company can return to its long-term growth ambitions of high-single-digit core earnings-per-share growth, it could deliver double-digit total annual returns without any multiple expansion.

Independent validation

I decided to add Abbott and P&G to my portfolio and increase my allocation to PepsiCo based on the individual merits of each company. However, I couldn't help but notice that they're all among the top holdings of the leading dividend-focused ETF, the Schwab U.S. Dividend Equity ETF. P&G is its third-largest holding (4.3% allocation), Abbott ranks 11th (3.8%), and Pepsi is 12th (3.8%).

The index this ETF tracks (Dow Jones U.S. Dividend 100 Index) screens dividend stocks based on several quality characteristics, including financial strength, dividend yield, and five-year dividend growth rate. Their high allocations in the fund show their relative strength among high-yielding dividend stocks. It's further evidence that they're high-quality holdings. As an investor in SCHD, I'm happy to increase my allocation to some of its top holdings, given its strong historical track record.

I'm taking the warning signs seriously but not panicking

A historically high CAPE ratio, combined with a Fed rate hike cycle, is a reason to be cautious these days. That's why I'm adding more defensive ballast to my portfolio by investing in elite dividend stocks like Abbott, P&G, and PepsiCo. They should be less volatile if there's a market storm, while still delivering plenty of offensive upside.

Matt DiLallo has positions in Abbott Laboratories, PepsiCo, Procter & Gamble, and Schwab U.S. Dividend Equity ETF. The Motley Fool has positions in and recommends Abbott Laboratories. The Motley Fool has a disclosure policy.