I wrote a piece earlier this year in which I pointed out that the S&P 500 had been trading in a relatively narrow dividend yield range since October 2009. Up to that time, the dividend yield on the S&P 500 had ranged between 1.8% and 2.2% and, since then, it has stayed in that range - winding up at 2.03% on Tuesday of this week (see www.multpl.com). Of course, dividends have been increasing the last few years and it appears that the increase in dividends, which is at least a major factor driving the market up.
So, exactly what does it mean to say that stocks are trading like bonds and what does it imply for the future? Bonds and stocks both produce yield but there are several major differences. It is probably worthwhile to review them here.
1. Bondholders are guaranteed to get their money back. Bondholders are entitled to receive the face value of the bond upon maturity. If it is not paid in full, they can institute legal action against the company and, in an extreme case, put the company into involuntary bankruptcy and seek to be paid from the proceeds of a liquidation. Shareholders have no right to get paid anything by the company itself and are completely dependent upon the market to get paid cash for their shares.
2. Bondholders are entitled to receive interest payments. The bondholders right to receive interest payments is a "creditor's right" and can be enforced. In contrast, a company can suspend or discontinue dividends at any time and a shareholder generally has no rights to institute legal proceedings against the company.
3. Dividends tend to increase over time. Whereas interest payments on bonds stay the same in nominal terms (and thereby are likely to decrease in real terms), dividend payments have had a strong tendency to increase (at least in nominal terms) over time and have increased steadily since the Crash of 2008-09.
There are several other differences - shareholders can vote to elect directors of the company, dividends receive more favorable tax treatment than interest payments, and bondholders have preference in a liquidation and also fare much better in Chapter 11 Bankruptcy proceedings.
Are stocks and bonds so different that it is simply impossible to compare? not really. For example, take difference Number 1. It is true that bondholders have an absolute right to get their money back but, in the case of an extremely long term bond, this right is a tiny fraction of the value of the bond's anticipated cash stream. During the Crash I bought Assured Guaranty (NYSE:AGO) and Allied Capital, now Ares Capital (ARCC) bonds of very long duration - some of the AGO's were nearly 100 years. A 6% 100 year bond will pay me a total of 700% of its face value during its term, discounting the value of the payments back to the present the value of getting the principal back 100 years from now is tiny. In reality, I (or my estate) will almost certainly sell the bond rather than wait for it to mature so that my payback depends on what I can get in the market - just as with a stock.
Dividends on any one stock can be cancelled or reduced but an investor can diversify (or use an ETF) to create a portfolio of stocks with respect to which the probability of an aggregate dividend decline is minimal. Not quite as solid as an interest payment on a AAA rated bond, but probably as secure as many intermediate or junk bonds.
Corporate management can also substitute debt for equity on the corporate balance sheet by borrowing money and using it to repurchase stock. It can move in the opposite direction by selling stock in a public offering and using the funds to pay down debt.
So it may not be entirely surprising that a "yield floor" under the overall market is beginning to emerge around 2.2%. Of course, the floor varies from stock to stock but the aggregate has remained remarkably steady. A good way to think of the stock market is as a fairly narrow highway heading up and to the right across a chart with the actual index price moving up with the highway but periodically shifting from the left to the right side of the road and never quite getting off on a shoulder. This long term trend line of the market is up at roughly the annual aggregate rate of dividend increases which seems to be in the 7 to 10 percent range. We may have a bit of a blip when some of the big banks like Citigroup (NYSE:C) and Bank of America (NYSE:BAC) resume paying sizeable dividends.
Of course, the ultra-low interest rate environment has reinforced, if not created, this phenomenon. The inability of investors to obtain decent returns on fixed income investments without taking some combination of duration risk and default risk has made equities comparatively attractive. In this regard, it is worth thinking through some of the events which could bring the party to an end. Here are a that occur to me.
1. Interest Rate Increases Before Economic Recovery - Sharp increases in interest rates could make equities much less attractive. Of course, if those rate increases occur only after a solid economic recovery (let's say nominal GDP growth of 6-7%), then corporate earnings and dividends will also increase. The most likely scenario is a recovery leading to a rally followed by higher interest rates leading to a correction. If for some reason, considerably higher rates were to occur without a strong economic recovery, equities would likely take a nasty hit.
2. A True Deflationary Recession - An actual decline in nominal GDP over any extended period of time would knock down corporate earnings and not only create a bearish climate on its own but might also lead to Number 3 on our list.
3. A Dividend Cut Surprise - In 1974, Consolidated Edison (NYSE:ED) cut its dividend and the entire electric utility sector tanked. Of course, it was a time when investors could find other sources of reliable yield. However, I think that a sufficiently nasty series of negative dividend "surprises" could sufficiently reinforce the notion that dividends are less secure than interest payments so that stocks in general could take a nasty header. In this regard, I do not have any candidates for the dunce cap because payout ratios are relatively low and corporate balance sheets are very strong. However, there are probably reasons to keep an eye on Verizon (NYSE:VZ) and AT&T (T) both of which have big dividends, considerable debt, and voracious capital needs.
4. A Leverage Incident - It is when we are most secure that the enterprising members of the species decide that opportunities to amplify returns through leverage are attractive. The best investment in the world can get crushed if overleveraged investors are required to sell off in response to margin or collateral calls. The floor which dividends put under the market is a wonderful thing for buy and hold investors but it will also attract more and more leverage as complacency sets it which may, in turn, set the stage for a leverage event comparable to those seen in 2008. One of the reassuring things about this rally has been the constant stream of negative sentiment and suspicion that one finds on sites like this one. When that chorus of doom ends, I am going to get up out of my seat and at least be sure that I know where the nearest exit is.
Apple (NASDAQ:AAPL) just increased its dividend by 15% and AAPL is still a big component of the S&P 500 so that the index will either trade up or its dividend yield will increase. I think we will see some more nice dividend increases in the next few months and the effect will be upward pressure on the market. I am generally long but investors should be cautious if the index yield falls below 1.8% and should definitely consider lightening up if it gets down to the 1.6-1.7% range. Investors should also watch out for the 4 dangers described above and be ready to react. Right now, I believe that equities provide superior opportunities to fixed income, but times change and sometimes they change pretty quickly.