Market undergoing huge change

MARK HULBERT Sept. 30, 2011, 12:03 a.m. EDT
Commentary: Market’s dividend yield now higher than T-Note’s
Believe it or not, the stock and bond markets are behaving in a way that, with only one exception at the depths of the 2008-2009 credit crisis, they have not since 1958—53 years ago: The stock market’s dividend yield is now above the interest rate on the 10-year Treasury note.

For example, the dividend yield on the Dow Jones Industrial Average is 2.8%, and on the S&P 500 index,  it is 2.2%. The 10-year T-Note yield, in contrast, is just 2.0%. This might not initially strike you as that big of a deal, but it is. Most investors who are active today cut their eye teeth during the go-go years of the 1980s and 1990s, when dividends were considered to be little more than an afterthought. Price appreciation was the name of the game. In fact, many of the most widely-held stocks paid no dividends at all. 


But what we’re seeing today could very well be heralding the return of the pre-1958 era in which the market’s dividend yield was consistently higher than that of 10-year Treasuries. In that long-ago era, the bulk of stocks’ total returns came from dividends. Price appreciation contributed relatively little to that total return, if anything at all.


What might account for such a shift to the previous pattern? The best analysis I have seen was published over a decade ago, in the March/April 2000 issue of the Financial Analysts Journal. It was written by Cliff Asness, who is managing and founding principal at AQR Capital Management.


Upon carefully analyzing the yield histories since 1927 for both the stock market and U.S. Treasuries, Asness concluded that the key factor in understanding them was investor expectations of the markets’ relative volatilities.


Prior to 1958, according to Asness, investors expected the stock market’s volatility to be much greater than bond market volatility. To entice investors to incur that greater volatility, the stock market had to provide a higher yield than bonds.


Then those expectations began to change, according to Asness, and with it investors needed a smaller dividend yield to entice them to hold equities. And that is why the stock market’s yield dropped below that of bonds, and stayed there for decades.


Asness’ theory also helps to explain recent developments. The stock market’s extraordinary volatility has so traumatized investors that they now need a much higher dividend yield to make holding equities an attractive proposition.


Will the current situation persist? According to Asness, it depends in no small part on investor expectations of relative volatilities, which is impossible to predict.


But Asness points out that investors’ memories live for a very long time. The memory of the Great Depression lingered for years after it ended, for example, which is one reason why stocks’ dividend yields remained so high for so long.


The bottom line? If investor memories of recent market volatility persist, then prepare yourself for an extended period in which dividends become one of the central preoccupations of the investment community.


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