Whenever bond yields fall below dividend yields, there is often a chorus of investors shouting out "Buy". I am not sure that, in and of themselves, dividend yields tell you a whole lot.
Sure, dividend paying stocks have outperformed equities over the past decade, but there is some survivorship bias impacting this too. Not to mention the fact that dividend stocks are so popular right now, some dividend champions like McDonald's trade at near historical high P/E ratios.
But I don't think you can simply ignore the fact that dividend yields on the S&P now are higher than treasury yields (as measured by the 10 year). Here is a chart of these yields going back 50 years:
Dividend Yields Vs Treasury Yields Back to 1962
click to enlarge
The blue line represents the yield on the 10 year treasury, and the red line is the dividend yield. These are annual averages, so while there was a brief month in 2009 when treasury yields fell below dividend yields, it didn't last long. Today it seems that again dividend yields are higher than treasury yields for the second time in 50 years.
What many investors ignore however is the payout ratio on dividend stocks. The payout ratio is the percentage of earnings paid out in the form of cash dividends. Today, the S&P500's payout ratio is 24%. Historically, that is very low. Corporate stinginess combined with a preference for buying back stock probably explains this low level.
In fact, here is a chart of the S&P500's payout ratio over time. Surprise, at its peak in the late 1980s, payout ratios were as high as 68% of earnings.
Payout Ratio Since 1962
Often investors also look at P/E ratios, and today's level tells you that stocks are somewhat cheap at 12.5x. For some context, P/Es have been as low at 7.5x in 1974 and 1982, and as high as 44x in 2000. By the way, the math on 12.5x earnings today is the S&P at 1330 (give or take) divided by $106 in estimated earnings for 2012.
S&P500 Price/ Earnings Ratio Since 1962
No wonder nobody made any money on stocks over the past 10 years. Valuations were absolutely quite high, the highest in this 50 year time frame.
I put together a final chart, one I think is more telling. That is, let's simply look at the earnings yield on the S&P 500, less the treasury yield over time. The earnings yield is the S&P500's earnings divided by the absolute level of the S&P 500. It's the inverse of the P/E ratio if you will.
I have heard that, adjusted for today's interest rates, stock appear cheap. Ok, but how cheap? Are bonds really that overvalued, and stocks really that undervalued? Well, here is the chart of the S&P 500s earnings yield, less the 10 year treasury yield over the past 50 years.
S&P500 Earnings Yield Less Treasury Yields (Equity Spreads)
Quite interesting. Today the S&P's earnings yield is right at 8% on an absolute basis. On a relative basis however, stocks appear cheaper than at any time over the past 50 years when compared to bonds. (To be clear, the 6.35% spread you see in the chart in 2012 is 8% less the yield on the 10 year of 1.65%).
In 1974, the S&P averaged 69 points. That is not a typo. In 1974 you could have bought the S&P500 for a mere 69 points. That is an 8% cumulatively compounded return, or approximately a 20 bagger on your money in 37 years. And that number is excluding dividends! Dividends would add a whopping 537 points to the S&P500 bringing you closer to 10% per year.
It's also interesting that in 1982, the year when the Great Bull Market in Bonds began, the chart clearly illustrates that stocks were quite rich compared to Treasuries, despite the fact that they traded quite cheap on an absolute basis. 7-8 times earnings seemed like quite a bargain back in 1982. But in fact bonds were the better risk reward.
I am not actually suggesting that one should run out and buy stocks today. But I am suggesting that long duration Treasury bondholders should run out and sell treasuries. Holders of US Treasuries may be in for a rude surprise if they keep them to maturity. You have to believe in years of deflation here for treasuries to offer any kind of real return.
But the data don't support deflation in the US. Here is CPI as reported by the BLS over the past 5 years in the US.
Given that the U.S. experienced inflation of 2.2%, through one of the worst recessions since the Great Depression, I cannot see a case whereby we have continued real, actual deflation over the next decade. One should also note that our government (which is inherently short CPI by the way via CPI-adjusted benefits), continues to under-report true inflation figures. This 2.2% number is probably more like 3%.
If we have 3% inflation, then 10 year bonds today will guarantee you 85% of the purchasing power at maturity. What is the probability that stocks earn less than 1.5% per year over the next decade? The yield this year is around 8% alone.
By the way, if you want to see what deflation looks like, here is Japan's CPI over the past few years:
If this level of inflation is the future in the US, then perhaps an investor can earn 1.5% in real inflation adjusted returns on treasuries. But seems like a stretch. Our population isn't declining, and our economy is not one driven by exports like Japans. Not to mention that Japan is losing share in the worldwide export market as China and other low wage cost economies increase manufacturing capacity.
From a pure trading perspective, it seems foolish to overweight equities with such turmoil going on in Europe right now. Not to mention the fact that the market always seems to flounder in the summer months. But by September, with a little panic selling as we approach some resolution in Europe, I think equities will look extremely attractive.
The downside case, that we have a recession and S&P earnings fall from 106 by 15% to $90 say, means that free cash flow yields will fall from 8% to 6.4%. That is still a near 5% equity spread to treasuries, historically an attractive long term buy level.
On an absolute basis, in a recession P/E ratios would increase from 12.5x today to 14.6x, still below the 50 year average P/E of 16x. Buying stocks at 14.6x recessionary earnings wouldn't be that terrible either.
While I am preparing for 10% or more in losses in the US equity markets, I am also preparing to put meaningful dollars to work in the equity world when it does happen. Stay tuned.