Dividend Yield Spread Over Bonds At Record Levels
On Thursday, the US weekly jobless claims were released, revealing 3.169 million people filed for unemployment claims last week. That brings the seven-week total to 33.5 million Americans out of a job in a very short period. Yet the S&P 500 closed up for the day at 1.15% and the Dow Jones Industrial Average increased by 211 points or .89%.
There are several opposing forces when looking at equity prices. On the one hand, the valuation on the S&P 500 is not favorable and on the other hand, the Federal Reserve programs are supporting the economy and stock prices. In addition, professional money managers must make tradeoffs among asset classes with the two biggest choices being stocks vs bonds.
In a normal environment, we would be very cautious because valuations are telling us investors have bid up prices on the S&P 500 too much. However, we are not in a normal environment and have to pay attention to all of the variables driving current stock prices. We mentioned the Fed and the tradeoff money managers had to make, but another force is the difference in yield between stocks and bonds.
Many investors rely on the cashflow from their investments to help support their living expenses in retirement, so they must decide between investing in stocks and collecting dividends or investing in bonds and collecting the coupon.
What we have seen in the past, when stocks became too overvalued, the dividend yield of stocks dropped and investors moved away from stocks and purchased bonds that paid a higher yield. For example, at the end of the first quarter in 2000, the dividend yield on the S&P 500 was 1.10%, while the yield on the US 10 Year Government Bond was 6.0%. This created an almost 5 percentage point spread in favor of bonds; therefore, it was an easy decision for income investors to move away from stocks that were paying such a low dividend to bonds paying a much higher yield.
However, today, it is the opposite and the yield on stocks are higher than the yield on bonds. For example looking at the MSCI ACWI (Index that represents stocks around the world), the dividend yield is 2.64% while the U.S. Treasury 10 Year Yield is .64%, creating a 2 percentage point spread in favor of stocks. We have not seen the spread this wide since the index was created. This has produced support for stock prices.
You can think about it this way, if you buy a 10 Year US Treasury Bond, you can lock in a .64% yield every year for the next 10 years, or you can buy stocks where the current yield is 2.64%. When we consider a total return perspective (yield and price appreciation) stocks look even more attractive for income long term investors. Bonds move opposite their yield. For instance, if yields go up, bond prices go down and if yields go down, bond prices go up. Looking at the chart below, we can see the yield on the US 10 Year Government Bond is at record lows, which means the potential for large price appreciation is not likely.
Although stocks are not favorably valued now and we expect more short-term volatility, as we have written in last week’s Market Update, we still think stocks make a lot of sense for long term investors. The key is to begin with a sound financial plan and a strong investment strategy, like the Tier approach we outlined in our Spring 2020 Quarterly Commentary.
If an investor has cash that they want to invest in stocks, a dynamic dollar cost average is the best approach now. For investors that are already in stocks, we think investing in companies with a strong balance sheet, good cash reserves, low leverage, low fixed cost and good profit margins is the way to go. We also believe overlaying this approach with companies that have a long history of paying and increasing their dividend will be rewarded by the markets for the reasons discussed above. We will continue to monitor the market environment and keep you updated as we move forward.