Equity, The Blind Optimist 5 comments
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SPDR KBW Bank ETF (KBE), invested in major US listed banks, now has a dividend yield of around 9% while the DOW Diamonds (DIA) yields half that.
This got me thinking about dividend yields on stocks. I suspect that DIA was the trigger: Charles Dow’s principles about how the market generally works, later dubbed Dow Theory, had at its core investors’ search for value and not, as now popularized, the confirmation by the averages, which was added later by others.
To Dow, value was sustainable dividend yield. Roughly, he believed a yield of anything less than 3% as being too low and 6% about right. Today, we have to adjust the headline dividend yield by stock purchases.
Many of us were nurtured on a paradigm which states that dividend yields, even after adjustment, are generally lower than bond yields, say 10 year corporates of equivalent rating.
As we can see, KBE and even the less threatened DIA are now challenging this paradigm.
One can argue, rightly in my opinion, that current dividends are not sustainable and have to fall even further and only then will we come to a point where we can apply Dow’s concept of a sustainable yield.
At the end of the road, though, we may still be surprised to find that dividend yields will exceed bond yields for some years to come.
Peter L. Bernstein, in his “Against the Gods”, notes that until 1959 dividend yields were higher than bond yields and that this had been the case since at least 1871.
Bernstein attributes the 1959 paradigm shift to inflation, which took off after the Second World War. The relative inflation-proofing obtained via stocks led to investors’ willingness to pay more for them relative to the income stocks produced. Since 1959, bonds yielded more than stocks.
The possibility of a deflationary environment apart, the reason why I suspect there is a moderately good chance that there will be another paradigm shift in the opposite direction, pushing dividend yields above bond yields once again, is the realization by many investors that the agency problem involved in trusting other people with one’s capital is much bigger than we previously suspected.
The helplessness of investors in the face of excessive CEO pay has now been compounded by the realization that we really don’t know what’s behind the balance sheet.
We thought that opaque balance sheets only belonged to technology companies, or maybe oil companies, but we now realize that the incentives of management and capital are at such odds that we even have to squint at banks, the cores of many pension funds’ equity portfolios.
The bottom line is that this realization is likely to increase the cost of equity capital.
Bonds can be inflation-proofed and one bond default throws a company into bankruptcy – so, with bonds, there is steel inside the glove. Equity is just jello. Changing directors and management triggers a bonanza out of the company’s coffers.
Equity is a blind optimist hoping that dividends will continue and not be cut, that the assets are there, that liabilities are not understated, that management is on its side, that laws and regulations will be respected, that inflation is measured correctly, and that eventually the exit price will be higher than the entry price. Hogwash!
With this crisis’ momentous historic slap in the face, a more realistic and rational equity would hopefully look at things differently.
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This article has 5 comments:
I doubt there is such a thing, and if my doubts are confirmed I will take that to mean what I have always suspected: bondholders are rubes, and the higher the credit grade the dumber they are. The reason hedging inflation out of a bond portfolio costs so much is that inflation takes that much. The market consistently underprices inflation; even so, a modest 2% out of a 5% nominal yield is killer. The real yield on AAA-AA corporate bonds is not much above zero, and if held in taxable accounts - I sing with joy at paying taxes on inflation "gains" - could well be negative. And it's not clear that the higher yields in the BBB space adequately compensate for credit risk; certainly anyone who bought them a year ago is wishing he hadn't, even if he plans to hold to maturity. At least junk buyers have the opportunity to benefit from mispricing of credit risk; with today's 20% yields a cagey researcher can pound the ground and maybe make a little money. There an inflation hedge makes a lot of sense; while gullible Mr. Market is busy listening to the government instead of looking at his own expenses, you might get a hedge out of him that costs you only 2-3%. That's a relatively minor chunk of your 20% yield, especially if 800 of those basis points are due to excessive pessimism. Even so, as an unleveraged trade this isn't going to make you a lot of money, and leveraged junk bond deals are just asking for trouble.
All of what you say about equities is true, but that doesn't mean interest rates don't need to rise as well. It would be quite reasonable to see the S&P 500 yielding 10% with 5-year BBB+ paper at 9.5%. Personally, I suspect that when the market wakes up to a $10T Fed balance sheet sometime next year and the true impact of that starts to sink in, 5-year Treasuries will yield 9% or more. Failed Treasury auctions wouldn't surprise me, either. So it certainly wouldn't surprise me to see corporates and dividend yields much higher than those numbers. The real interesting question is whether dividend yields of 12% could ever be sustainable; in the 1970s we saw P/Es as low as 7, and we'd need to be below that for 12% to work. In other words, interest rates that adequately compensate investors for both credit risk and inflation would almost guarantee that either dividend yields remain well below bond yields or the stock market collapses completely. Interesting times.
It is strange that bonds have a higher yield compared to stock yields because stocks carry a higher risk.
It is logical that inflation is the main culprit here; but what was the main cause of all that inflation during so many decades?
__________Begin intermezzo
To Bearfund: US economical theory is the problem, please concentrate on the real long term problems that gave rise to the present situation.
For example: House prices are hefty undervalued in the consumer price index, now the USA pays a costly price for that.
All these years in the housing boom, consumer inflation was measured too low because of the weird consumer inflation statistics the US government uses.
Now you folks pay the price for that...
Blame the US economists please!
__________End intermezzo.
Mostly US (but also European) economists that argue that a small and slight inflation is 'good' for the economy.
Those economists had one thing wrong; in the basis of their thinking they thought that deflation was the reason for the long time the depression lasted.
They interchanged cause and effect; deflation was an effect of the crisis, not a cause. Ok ok. it made the crisis longer but that is not a reason to fight deflation during normal times.
On the contrary, in consumer paradise 1 or 2% deflation is like the rain that makes sure in a decade you can spend also like you do today...
For me it is strange to observe all those batallions of US economists standing outside normal economical thinking for so long. I guess this is one of the damages when you become a world power; when you start thinking rubish there is nobody to ram you back into reality.