Comparing dividend yields vs. bond yields
Frequent readers of dividend blogs will know that most sophisticated dividend stock investors compare dividend yields to bond yields (or high yield money market funds) as one quantitative measure of assessing risk and valuation (see Dividends4life’s analysis of Johnson and Johnson as an example). But what are we to make of the strange behavior between dividend yields and bond yields in the last six months?
The conventional pre-1950′s thinking was that, given that equities are, by nature, a riskier investment class than fixed income, equity needed to pay out greater than fixed income returns to over-come the structural risk. After all, why would you invest in something without some cash being returned to you over the life-time of your investment (oh, how times have changed!)? Since anyone could purchase U.S. treasury note with guaranteed payment, dividend yields needed to be greater than treasury yields to entice investors to invest in equities.
How great? One researcher found S&P 500 dividend yields from the period of 1871-1967 were approximately 20% greater than AAA corporate bond yields.
However, from 1958 until December 2008, dividend yields of the S&P 500 have paid less than the interest on a 10 year treasury note by an average margin of 3.6% in favor of bonds. In December 2008, the pre-1958 pattern of dividend yields being greater than bond yields reverted due primarily to plunging stock prices.
But with the recent rise of the stock market, dividend yields on the S&P 500 are now equal to or lower than yields on a 10 year treasury note, meaning a return to the 1958-2008 era. Assuming this pattern continues to hold true, and the period of December 2008 to circa May 2008 a blip in the continuing trend towards bond yields paying more than dividend yields, what do we make of all of this?
On a relative basis, one could argue that our general perception of risk, even 18 months into a economic downturn, may not have undergone a large shift. Unless one assumes that total return of a stock (dividend plus stock price increase) will be greater than a guaranteed fixed income instrument in a % than negates the relative risk of investing in equities, common sense thinking would dictate that an investor, in a volatile market, demand a dividend yield which would be greater than guaranteed fixed income yield as downside protection of this investing environment. Call this the “bird in the hand” school of investing.
While risk perception individually may be acute, the market, as a whole, by driving down dividend yields below fixed income yields appears to be ignoring the bird in the hand school of investing and thinking that a 1958-2008 era of focusing on total returns is about to return. It remains to be seem whether this analysis is true but it is premised on the assumption that we should rely on stock price appreciation more than dividend payment as basis of equity valuation. The existence of this school of thought, despite recent market shocks, may be due to the fact that many of the players who drove the market to bubbles continue to remain in charge, such being the complicated nature of the system created today that the only people who can steer the economy to a safe landing are the people who crashed the plane in the first place.
On an absolute basis, what are we to make of the fact that dividend yields are heading below 3%? If you are an old-school investor, a dividend yield of the S & P 500 of 3% or below is conventionally thought of as a warning sign to move from equity to other asset classes; by the middle of this decade, when the first of the bubble warnings begun, dividend yield was hovering around 1.5%-2%. In other words, plunging dividend yields can be used as an indicator that stocks are over-valued and a correction is forthcoming. Dividend yields of the S & P 500 fell to 3.12% as recently as May 7.
If you are in the glass half empty camp, you read the S &P 500 dividend yield moving down towards 3% as a sign this is a false market recovery: too much money sloshing around with too many active managers with itchy fingers. If you are in the glass half full camp, you believe that this is a return to the go-go days of 1958-2008 and that dividend yields are not as important as a total return analysis. If you a believer that hyper-inflation is coming, then dividend yield will be the only thing that matters going forward since we are approaching not the 1930′s but the 1970′s where the stock market went side-ways for a decade and most of one’s return on equities was based on dividends and not price appreciation.
Is this as clear as mud? Of course it is. It only means that the only certainty is uncertainty (and beware anyone who says they can predict anything with certainty- they suffer from the emperor has no clothes syndrome) and, if you used dividend vs. bond yield as an indicator of asset allocation (which is one of many tests), the recent market uptick of the last 9 weeks is far too small of a sample size to form a basis of large-scale decision making.