The Market Is Still A Bit Overpriced In Terms Of Dividend Yield

by: Philip Mause

I have written before about the uncanny reliability of the dividend yield metric, explaining it initially here and updating the analysis here. Given the recent pullback last week, it is helpful to update this analysis and assess where we are.

The Metric - The metric is based on trailing twelve-month S&P 500 dividends. Since the Fall of 2009 (four and a half years ago), the S&P 500 has stayed in a relatively narrow range in terms of dividend yield. Another way to look at this is by stating that almost all of the gain in the average is due to increased dividends. The range is between 1.8% on the low side and 2.2% on the high side. A higher dividend yield tends to mean lower stock prices and vice versa. When the yield gets close to 1.8%, the market has tended to pull back; when the yield gets near the 2.2% limit, the market tends to rally. We were at 2.2% in the late Fall of 2012 before a major rally, and we were getting near 1.8% in the Summer of 2011 before a big pullback. 2% is the mid-point in the range and could be viewed as "fair value". The range has prevailed in a variety of interest-rate environments, including periods with 10-year Treasury yields well over 3% and periods with 10-year Treasury yields well under 2%. One important thing to bear in mind: dividends have been steadily increasing so that, while the percentage yield has stayed relatively constant, the range itself (in terms of stock prices) is always moving up. Since 2010, we have experienced a very strong period in total dividend growth because some companies - for example, Apple (NASDAQ:AAPL) (the index's largest component) - have initiated dividends and others have been steadily increasing them.

Where Are We Now? - At Friday's close of $1790.29, we are still a bit below the 2% mid-point in the range. I am assuming that dividends as of January 1, 2014, were $35.19 (the December 1, 2013 number plus 20 cents). Based on Friday's close, this gives us a dividend yield of 1.97%, or a bit below 2%. Filling out the range, a 2.2% dividend yield would imply a $1599.50 price for the index and a 1.8% dividend yield would imply a $1955 price. We are priced a little bit above the middle of the range ($1759) so a that further correction should not be a big surprise. While the correction could go below that number, I would be very surprised to see the S&P 500 break below $1600. In addition, dividends themselves will tend to go up each month so that in a month or two, the current price level will migrate to the middle of the range and ultimately toward a yield higher than 2%, which would begin to flash a buy signal.

Dividend Trends - Dividends have been increasing at a furious pace and we are likely to have another year with a double-digit percentage increase. I am watching certain stocks very closely in this regard. Citigroup (NYSE:C) and Bank of America (NYSE:BAC) were at one time big dividend stocks and now pay only nominal amounts. A resumption of big dividends by these two would help move the needle. In the long run, it is mathematically impossible (or at least very, very difficult) for dividends to increase at a higher percentage than earnings, but given relatively modest payout ratios and large cash reserves, we could experience higher percentage increases in dividends in comparison with earnings increases for at least several more years. In the very long run, however, dividends depend upon earnings, and so we must watch the earnings trend as well.

Why Does This Metric Work? - I think that this metric works for several reasons. One reason is that dividend investors tend to "come to the rescue" as the market sags toward a 2.2% yield. While a 2.2% yield does not seem enticing, it should be noted that, if the overall market has a 2.2% yield, there will be many, many stocks yielding between 3 and 4% which will begin to look very attractive in comparison with bonds. A sagging market also tends to reinforce the share repurchase phenomenon. Many share repurchase programs are authorized with a dollar amount limit. A company spending a fixed amount each month on share repurchases will repurchase more shares in a down market. I think that the market may attract a different group of investors as the yield approaches 2.2 %. These investors tend to be yield-oriented and tend to make bond/stock comparisons. As the yield drops to 1.8%, we are likely in a market in which speculative money is chasing certain "growth" stocks which do not pay dividends at all. As dividend yield increases, there also may be more purchases by investors in collateralized loan accounts, where investors can actually earn a "spread" based on dividend yields being higher than the interest rate on the loan secured by the account.

What to Expect - I think that dividend increases over the coming year will be in the 10-12% range, getting us to a total Index dividend of roughly $39 by the end of the year. This is a relatively conservative estimate because percentage increases have generally been higher in the last few years. However, we are now working off a higher base in terms of total dividend amounts, and increases in the mid-teens cannot go on forever. Using my assumption, the metric implies a range with a high of $2167 (a 1.8% yield), a low of $1773 (a 2.2% yield) and a mid-point of $1950.

Recommended Strategy - I generally view the investment spectrum as having two extremes - ultra-safe Treasury bonds on one end of the spectrum, and growth stocks that pay no dividends at the other end of the spectrum. The spectrum increases risk as we move from Treasury bonds to investment grade bonds, then to riskier bonds, then to yield vehicles (BDCs, MLPs and REITs), then to yield-oriented stocks and finally to growth stocks. Because I believe that a market correction will be accompanied by lower interest rates (as it has been so far) and that a subsequent rally will start with yield-oriented stocks and yield vehicles, I recommend that investors now focus on stocks with higher-than-average dividend yields such as Philip Morris International (NYSE:PM) (4.6%), Verizon (NYSE:VZ) (4.5%), AT&T (NYSE:T) (5.5%), Lockheed-Martin (NYSE:LMT) (3.6%), Proctor & Gamble (NYSE:PG) (3.0%), Microsoft (NASDAQ:MSFT) (3.0%) and Johnson & Johnson (NYSE:JNJ) (2.9%) as well as yield vehicles such as Lexington Realty (NYSE:LXP) (6.2%), Ares Capital (NASDAQ:ARCC) (8.7%) and Kinder Morgan Energy (NYSE:KMP) (6.6%). These stocks will tend to move down less in a correction and to rebound faster after the correction because a correction will take averages nearer to the 2.2% dividend yield resistance level, at which dividend-oriented investors will begin loading up on stocks. An investor who follows this strategy will continue to earn yield while events unfold and will hold those stocks which will benefit the most when dividend investors start to load up.

Disclosure: I am long AAPL, C, BAC, MSFT, PM, PG, VZ, T, JNJ, LMT, KMP, LXP, ARCC. 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.