This isn't exactly news, but with the 10-year treasury yield at around 1.5%, I'm getting more concerned about the distortion between interest rates and dividend yields.
If your memory of the stock market only goes back a few years, ask yourself this key question: Why should a consumer staples company like Procter & Gamble (NYSE:PG) yield 3.7% while a 10-year treasury bond yields about 1.5%?
The answer is: it probably shouldn't. And over the past 30 years it has not - except recently after the 2008 financial crisis.
I'm not picking on Procter & Gamble, just using it as an example to pose the question -- Is this a "new normal" or just a temporary distortion?
Not all stocks have behaved this way, of course. Consider a utility like Consolidated Edison (NYSE:ED). As you can see, it has tracked the 10-year bond rate a lot more closely.
That's because utilities tend to behave a lot like bonds. Utilities don't generally offer growth, but they usually do provide dependable cash flow that's returned to shareholders in more of a bond-like kind of way.
If rates rise, income stocks fall
So how could the relationship between the yields of stocks like PG change with respect to bonds?
Someday interest rates will rise. I know it seems far-fetched now, but if you could get an 9% yield on a six-month CD, would you be tempted to sell a dividend growth stock and take the 9%?
You might not, but some would. That's why rising interest rates can be bearish for stocks overall, especially dividend paying stocks - unless the reason for owning a stock extends beyond the dividend (like growth, special situations, etc.).
And consider that if treasury rates rise, there's little appeal to owning a utility like Con Ed unless its yield also rises to keep up - and that causes downward pressure on the price of the stock.
Dividend stocks: Fast relief from bond yield pain
This chart shows Case-Shiller's data on dividends for the S&P 500 going back to 1953. Note that the spread between the S&P 500's yield and the 10-year treasury bond has been narrow for years now. But how long can that last?
What's happening right now is that the Fed is trying its best to make it so painful to stay in bonds that being in stocks like Procter & Gamble (or other riskier assets) seems like euphoria in comparison. But once the Fed stops being such a pain in the rear, dividend stocks may not provide such a powerful analgesic effect anymore.
Sure, a consumer staples stock at a 3.7% yield seems good now, but if banks start offering six-month CDs that yield 9% (and It could happen sooner than you think), the stock becomes a lot less attractive unless investors see other non-dividend reasons for owning it.
If you're a committed dividend growth investor, what should you do?
If we're indeed headed for a few years of lower than average price gains for dividend paying stocks, that's actually good news for you as you'd be acquiring shares at lower prices. That will help lower your cost basis and give you a much higher yield 10, 20, or 30 years from now.
So if you're young and you have decades of time on your side, you can stick with your dividend growth investing plan and do just fine.
Just remember that interest rates will rise someday. It may not happen soon, but the rise could be rapid once it begins.
If six-month CDs start yielding 9%, it'll be tempting to move some of your money to cash for six months. I wouldn't blame you if you did - but if you've got a long time remaining until retirement, I probably wouldn't leave that cash there for too long.
Disclosure: I am long PG.