The Dividend Yield Model Is Flashing A Strong Buy Signal

by: Philip Mause


Since 2009, the dividend yield on the S&P 500 Index has stayed between 1.8 and 2.2 percent until recently.

As of Friday's close, the dividend yield on the index was 2.31 percent, which suggests that stock prices should go up to bring the yield back into the range.

Even if we assume that the range should be moved up based on recent Federal Reserve action, we would still have a range of 2.0 to 2.4 percent.

Under this new range, the midpoint would be 2.2 percent, suggesting that 2.31 percent is an attractive entry point.

This is confirmed by the fact that the dividend yield on the index is now higher than the yield on 10-year treasuries.

As I have written in the past, here, here and here, since the 2008-09 Crash, the dividend yield on the S&P 500 Index (the "Index") has persistently remained in a narrow range of 1.8 percent to 2.2 percent with 2.0 percent as the midpoint. As a general rule, when the dividend yield on the Index approached 2.2 percent, it was a signal that an attractive entry point had been reached. The dividends used for this analysis have been trailing 12 month dividends. Of course, the Index has moved up over this time period but the gains are almost entirely explained in terms of dividend increases. In most years since 2009, in most years there have been double-digit percentage increases in the dividends paid by the Index and this has propelled the stock market higher.

The market closed Friday at a price of $1880.83 for the Index. Using trailing dividends of $43.39, the dividend yield for the Index is now 2.31 percent. This is outside the range and is either a very strong buy signal or a sign that the model has broken down. One reason that the model may have broken down is that the Federal Reserve has, for the very first time since the Crash, raised interest rates. It would not be surprising for investors to insist on higher dividend yields if they are able to obtain higher interest rates on risk free treasuries.

Using year over year comparisons, the yield on short-term treasuries has increased by roughly .2 percent. If we assume that the model's range should be increased by a similar amount, it would produce a new range of 2.0 to 2.4 percent with a midpoint at 2.2 percent. Even under this new range, 2.31 percent is well above the midpoint and suggests a good entry point. The chart below provides some relevant yields under the old model and the hypothetical new model together with the Index prices corresponding to those yields.

Dividend Yield Index Price
2.0% $2170
2.1% $2066
2.2% $1972
2.25% $1928
2.4% $1808
2.45% $1771
Click to enlarge

It would seem that, even assuming that the model should be adjusted for the Federal Reserve's recent action, the fair value of the Index (the midpoint of the range) would be $1972 and that there should be a strong base of resistance at a yield of 2.4% or $1808. If it is argued that the model should be adjusted by .25% because that is arguably the amount of the intended rate increase, then fair value would be $1928 (the 2.25% midpoint of the range) and a strong base of resistance should exist at 2.45% or $1771.

Readers should note that the trend of higher dividends has slowed down but continued. As of the first of the year, year over year dividends on the Index increased by 8.8% even though problems in the energy sector led to dividend reductions for affected stocks. This year, problems in the energy sector may actually have less adverse effects on the Index dividend levels because the weighting of energy stocks in the Index has declined considerably. So, assuming that the range stays the same, dividends and, therefore, stock prices should increase.

Other indicators suggest the validity of this analysis. The yield on the Index is now higher than the yield on 10-year treasuries (2.19%). There are now a large number of "safe" dividend stocks with yields in excess of 3% and a considerable number with yields over 4%. Buyers of "baskets" of these stocks who intend to hold them for 10 years will almost certainly do better than buyers of 10-year treasuries. The fact that the dividends are considerably higher than the interest payments on the treasuries will mean that the buyers of the stocks will do better unless, 10 years from now, the stocks suffer price declines massive enough to offset the extra yield that the stock buyers will obtain.

The model has proved very reliable since the Crash and, even with a reasonable adjustment, the model is now flashing a clear buy signal. The model also suggests that strong resistance should emerge if the market declines to the $1771-1808 price range.

I do not anticipate another Federal Reserve rate increase unless and until the evidence is very strong that another recession is not on the horizon. By the time that evidence emerges, dividends will have increased and the expectation of future dividend increases will be stronger.

Disclosure: I/we 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.