What does dividend yield tell us about the economy?
Chasing abnormally high dividend yield is typically seen as a sign of imprudent dividend investing. Since dividend yield is ratio of annual dividend payment to share price, an abnormally high dividend yield generally indicates the share price has collapsed or the dividend paid is quite high, leading to questions about sustainability and future growth. But, on a larger macro level, a large basket of dividend yield stocks serves as a proxy of return of capital in equities. As such, dividend yield can also be an indicator of larger economic trends.
- Comparing dividend yield vs. 10 year treasury yields revels market appetite for equity risk. Since 1958, the S & P dividend yields have only exceeded 10 year treasury yields twice: once in 1958 and once in 2008. As I noted before, it seems strange that money would rush into a riskier investment (stocks) that produced less yield than a guaranteed instrument unless you believed capital appreciation would more than make up the difference of a low dividend yield vs. bond yield. You end up in this particular situation because the market is confident of capital appreciation going forward and that the risk premium in investing in equities is manageable. Conversely, decreased appetite for risk should result in a decrease in the spread between treasury yields and dividend yields (as witnessed in 2008 when the market had no risk tolerance).
- Large gaps between treasury yields vs. dividend yields can be read as a danger sign. Large gaps between 10 year treasury yields and S & P dividend yields occurred in the early 1980′s, explained by the rise in interest rates. They occur again during the tech boom, caused by the rapid rise in stock prices. In the latter instance, as history attests, this large gap reflected an unsustainable run up in equity prices not justified by any fundamentals; the lesson being the larger the gap, the larger the danger of a correction. In the former instance, the guaranteed yield on government issued debt would impede capital to public markets.
- In zero to low interest environments, dividend yields exceeding government bond yields tend to produce rallies… for a while. Japan has had a de facto zero interest rate environment for the better part of two decades. In 1998, 2003 and 2005, dividend yields moved higher than government bond yields triggering a market rally each times; in essence, the market said “things can’t be that bad that we are investing in essentially 0% government paper.” However, the 4th time this happened in 2007, the rally did not occur. Perhaps the issue is that you can only stimulate the economy for so long with low to zero percent interest rates before one realizes that there are real structural issues with the economy and the market rallies, short as they are, mask a more fundamental issue (a scary possibility for the American economy).
- Dividend yield and growth is arguably the best indicator of future market returns. The esteemed William Bernstein recently wrote about Professor Myron J. Gordon who predicts long term stock market growth through a simple formula. Over long period of time, average equity growth = dividend yield + historical dividend growth. Historic dividend growth is 4.3%. The rationale behind the formula is elegantly simple. Smart companies generally do not increase dividends unless they are profitable. Profitability increases stock price. Thus, working backwards, stock price growth is related to dividend growth. If many companies continue to hold the line on dividend increases or increase them below the historical rate, the market could be in for a rough ride.
- Dividend yields can be a demographic indicator. There appears to be an inverse correlation between S & P dividend yields and mutual fund in-flows. As the baby-boomers begun to invest for retirement, we witnessed a focus on capital appreciation over cash in hand and a decline in dividend yields. But, as noted above, in an aging population like Japan’s, you have a flight back to safety with a reversion back to the mean despite multiple rallies. It would appear that a long march upwards for dividend yields may not be a positive development for the market as a whole.
What does this all mean? Dividend yields can be predictive of market movements ahead. Since they are proxies for equity risk, albeit an imperfect one, a snap shot of yields can give you insight into the market’s risk tolerance.
The dividend yield of the S & P 500 stood at 2.28% as of September 30 of this year. Is this too high or low? Only time will tell.