Since May 29, 2013, the financial markets have been witnessing, not for the first time though, something shocking: the 10-year US Treasury Note yield matching the S&P 500 dividend yield. Is this something that investors really need to worry about? Since I'm aware of the time constraints that most of the readers of Seeking Alpha have, I will give a short and a long answer.
The short answer: Yes, but not "terribly worrying," investing in the S&P 500 is just somewhat riskier than before.
The long answer: Higher risk and (certainly) not higher expected return is something that should worry any investor, to some degree at least, and in my opinion this event was (and still is) a warning sign that should not be overlooked.
Think about it, the matching of the two yields means that when an investor considers whether to invest in stocks or in bonds, the "fixed" yield of the first asset is the same as the total yield of the second one, but the first asset has a "variable" yield as well, namely, the capital gain, which can be positive or negative - it has some risk. Then, as stocks are risky, investors require a "market premium" of roughly 6% (on average) according to Dr. Pablo Fernández empirical findings, which in this case would mean about an 8% annual return for the S&P 500 for the next 10 years. Intuitively, this is hard to believe (can you see the S&P rising about 116% after 10 years?), especially because we have examples like the period 2000-2010 in which the S&P returned -22%. The situation gets worse as the yield of the risk-free asset surpasses the dividend yield of the S&P, and the larger the gap between the two yields, the clearer it is to see that the market must make an adjustment soon.
Indeed, the current situation (the 10 year US T-Note yields 1 percentage point more than the S&P dividend yield) does not seem sustainable in the long run, intuitively at least. Perhaps the market is actually making the adjustment right now, as the S&P 500 has started to go down the moment the yield gap approached 1 percentage point (3% vs 2%) at the beginning of August, as shown in Figure 1. Causation or just correlation? Time will tell.
Then, in order for the yield gap to close, either of the following two events must happen:
a) The yield of the 10-year US Treasury note decreases
b) The dividend yield of the S&P 500 increases
Let's examine if A) is likely to happen. A) is equivalent to say that the price of the 10 year US T-Notes increases (due to the inverse relationship governing the price and the yield of a bond), which in turn is equivalent to say that the demand for 10-year US T-Notes increases, but this does not seem likely at all since Ben Bernanke announced at the end of last month that the Fed has the intention to start tapering its unprecedented $85bn a month program of Quantitative Easing, perhaps as soon as this month. Therefore, alternative A) is not likely to occur.
Then, what it is likely to happen is alternative B), and in order for that to happen, the S&P 500 must go down: recall that dividend yield = dividend/price, and if we assume the numerator to be fixed (which makes sense if we consider the average dividend policy of all the S&P constituents), then the only way the whole ratio can go up is by decreasing the denominator, which, by the way, makes perfect sense, since money flies to wherever happens to be a better risk/return opportunity, and right now maybe there's too much risk in holding a long position in the S&P 500 considering its relatively low expected return.
However, it is true that the S&P 500 has not performed badly at all since May 29 (reaching its all-time-high in August 2), and now we have the S&P at roughly the same level as at the end of May. But make no mistake, the fact that we have not seen a bearish trend in the S&P 500 since May 29 does not imply that the matching of those two yields is not a warning sign; on the contrary, as Dr. Didier Sornette often likes to say: "when an instability has developed, and the system is ripe, any perturbation makes it essentially impossible to control."
And so what could be that perturbation? The Syrian conflict, for one: remember how the markets reacted to the missile false alarm just a few days ago? Imagine now what could happen if that had not been a mere false alarm.
I would like to end this article with a non-dramatic conclusion, but realistic nonetheless: despite the decent long-term prospect from a purely technical analysis viewpoint (see figure 2), the S&P 500 (among other markets) is undergoing a situation of high instability, which makes it very fragile, and it is indeed possible that we will witness the start of a bearish trend if some serious perturbation (other than a "false alarm") occurs. The time window is very hard to predict, but it would be wise, perhaps, to start preparing ahead of time and close open long positions (or avoid opening new ones) in the S&P 500 until the instability decreases.
Finally, note that the fact that the dividend yield of the S&P is lower than the 10 year US T-Note yield alone is not something (very) worrying (it has happened other times before), but if you add the fact that the S&P is very close to its all-time-high, and plus that there is a high global instability (for example due to the Syrian conflict), then the overall conclusion must be that a moderately bearish trend might be just around the corner.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.