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With Washington threatening to drive the US off a fiscal cliff, stock ETFs have taken a hit since the election. As of 11/14, [[SPY]] is down -4.92% and [[VTI]] is -5.05% since Tuesday 11/6. Moreover, given the uncertainty about how dividends will be taxed after January 1, dividend ETFs have also been hit pretty hard, as shown in the table below.

The end column on the right shows the ratio of the drop in market price to the Morningstar trailing twelve month dividend yield (unless the ETF is less than a year old). In essence it indicates how many years of dividends have been wiped out by the recent drop in prices. Vanguard's dividend growth fund, VIG, as been the hardest hit, losing the equivalent of almost two years' worth of dividends. By contrast, the S&P 500 low volatility ETF, SPLV, has lost the least, somewhat over one year's worth.

What to do? One option, of course, is to "keep calm and carry on." After all, while you wait for prices to recover, you still get to collect your dividends. But things could get nasty over the next six weeks, so another option is to sell into the next bounce, stay in cash until volatility subsides, and reenter at a lower price. If you time it right, you might even get a capital gains loss for your 2012 tax return.

Here's a third option: look overseas for a global ETF that may be less affected by the turmoil in the US. One candidate is iShares MSCI EAFE Index ( EFA ), which tracks the performance of all developed markets outside of North America, namely Europe, Australasia, and the Far East. Europe dominates, accounting for 63% of the fund's holdings, followed by Japan (19%), Australia (10%), and other developed Asian economies (5%). At $36B it has the fourth largest assets under management among all equity ETFs, and its trailing twelve month dividend yield is 3.21%. As the mini table below shows, only SPLV has outperformed it since the election, although EFA offers a higher dividend.

But why EFA? Check out the chart below, which plots the ratio of EFA to Vanguard's U.S. Total Market Index ETF ( VTI ) (Stockcharts). The red/green line represents the ratio's weekly close, while the blue line is the ratio's ten-week (50 day) moving average. When the line representing the ratio moves upward, EFA is outperforming VTI; when it moves downward, VTI is doing better.

(click to enlarge)

Note that since the middle of July the ratio has been moving higher and has been almost continuously above its ten-week moving average. This means that EFA has been outperforming the US stock market for the last four months. If this trend continues, then EFA, not VTI may be the investment of choice for the near future.

Moreover, EFA pays a better dividend (3.21%) than all but three of the dividend ETFs in the first table: HDV (3.25%), DVY (3.48%), and PEY (3.87%). And, as the chart below suggests, EFA's prospects for dividend growth seem pretty good.

(click to enlarge)

As the chart shows, EFA's annual dividends rose sharply from 2003 to 2007, then dropped until 2010, and rose again in 2011. To model this data I chose an exponential function based on the ETF's dividend growth rate from 2003 to 2010. Between these two years the dividend grew from $0.5525 to $1.3968, which represents a 14.17% compound annual growth rate. The resulting curve [y= 0.479*(1.143^(x-2002)] forms a lower boundary for the actual dividend data and reproduces the calculated growth rate. Using this function I estimate that the annual dividend payouts for 2012 and 2013 will be $1.82 and $2.08, respectively.

In June 2012 EFA paid a dividend of $1.1491, suggesting that its December 2012 payout may be about $1.82 - 1.15 = $0.67. This seems to be in the right ballpark, since its December 2011 dividend was $0.5692. If the full-year estimate of $1.82 is correct, then an investor who bought EFA on January 3, 2012 at 50.88 (unadjusted price) will earn a 3.58% dividend this year. Moreover, if the full-year estimate for 2013 of $2.08 is correct, then an investor who bought EFA at today's (11/14) closing price of 51.95 will earn 4.00% next year, in addition to 1.29% from this December's payout. That's not too shabby.

Of course, these are just projections, and real life frequently confounds any attempts to model it. Perhaps the most cautious approach is to wait until December's dividend is announced to see if it conforms to the projection. If it does, then the case for buying EFA will be strengthened. If not, and especially if the 2012 dividend falls well below the projection, then caution will be called for.

Bottom line, if Washington doesn't drive the country off the fiscal cliff but reaches a deal that nevertheless raises taxes on dividends, either in 2012 or 2013, then US stocks and dividend-paying ETFs may well continue to decline, possibly substantially. Foreign stocks will probably also be affected, but iShares MSCI EAFE Index may outperform US benchmarks, as investors in Europe, Australasia, and the Far East may not see any increase in their dividend tax rates. Under this scenario, US investors may want to consider selling their domestic dividend ETFs and buying EFA instead. On the other hand, if Washington gets gridlocked as it did in late July and early August of 2011 and no agreement is reached, then cash may outperform all dividend ETFs in 2013, regardless of their nationality. Only time will tell.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: I am not a registered investment adviser and do not provide specific investment advice. The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusions.

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