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How Long Can Stocks Yield More Than Bonds?

As long as inflation is tame, Fed policy supports the dividend trade

   

Stop me if you’ve heard this one before: Low yields on government bonds are causing investors to gravitate toward dividend-paying stocks.

If you’re tired of reading about this trend, don’t expect relief anytime soon. Later this month, The Federal Reserve is likely to announce its intention to keep interest rates at their current ultra-low level until mid-2015. If the Fed follows through on this plan, it will mark the second time this year that it has extended its low-rate horizon.

In January, the Fed announced its intention to keep rates low through late 2014 — a change to its previous guidance that rates would stay near zero through the middle of 2013. This means at least three more years under the current policy structure, which would make the Fed’s zero-rate policy six-and-a-half years old at its planned conclusion. In comparison, Japan kept rates at zero for only five years, from 2001 through 2006.

What does this mean for the financial markets? In short, more of the same. Most of the major stock indices have been out-yielding bonds for more than a year now, and there’s no reason to expect that to change dramatically in the near future. As of Sept. 5, all four major equity asset classes — as represented by ETFs — continued to offer 30-day SEC yields above that of the 10-year Treasury note:

SECURITY Ticker YIELD, 9/4
10-Year Treasury N/A 1.58%
SPDR S&P 500 ETF SPY 1.91%
iShares Russell 2000 Index Fund IWM 1.73%
iShares Trust MSCI EAFE Index Fund EFA 4.48%
iShares MSCI Emerging Markets Index Fund EEM 1.89%

And this doesn’t even get into the myriad products designed specifically to capture yield, such as the Dow Jones Select Dividend Index Fund (NYSE:DVY) at 3.56%, or the WisdomTree Emerging Markets Equity Income Fund (NYSE:DEM) at 3.33%.

Given that short-term rates seem destined to remain at their current levels for another three years, the key question is “What would cause a sustained shift in the relationship between the yields of stocks and bonds?”

The leading answer, of course, is inflation. While short-term bonds are heavily influenced by Fed policy, the longer end of the curve is much more sensitive to inflation expectations. Any whiff of rising prices therefore would be a prime catalyst for the long-awaited sell-off in Treasury prices, which would cut into stocks’ advantage. But with capacity utilization below average and unemployment remaining stubbornly above 8%, there’s no reason to expect that inflation will begin to tick up in the near future — no matter how much money the Fed pumps into the system.

equity vs bond 300x118 How Long Can Stocks Yield More Than Bonds?
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A situation in which stocks out-yield bonds is more common than one would expect based on recent history. The accompanying chart — which was developed by Global Financial Data and was the subject of a blog post on ritholtz.com — shows that stocks actually offered greater yields than the 10-year Treasury for the majority of the period from 1871 through 1956. Granted, the absolute yields on stocks were much higher during that period. Still, the accelerating dividend growth for U.S. equities — as highlighted by this year’s dividend announcements by Apple (NASDAQ:AAPL) and Cisco Systems (NASDAQ:CSCO) — have helped fuel a steady rise in equity yields during the past decade, a key factor in their current advantage over government bonds.

The bottom line: It’s true that the current yield relationship between stocks and bonds is a direct result of the Fed’s financial repression. But with this policy on track to stay with us for another three years, the central bank is giving investors a clear green light to keep reaching into higher-risk areas of the market for yield.

Until there’s a fundamental change, market downturns should continue to represent an opportunity to capitalize on this multi-year trade.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, http://investorplace.com/2012/09/how-long-can-stocks-yield-more-than-bonds/.

©2014 InvestorPlace Media, LLC

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