Citizen Kass pointed out yesterday that the dividend yield on the S&P 500 is now higher than on 10-year notes, for the first time since the 1950s. It also happens to be true in Japan, where the Topix yields almost twice as much as 10-year JGBs.
The conventional wisdom is that this signals that stocks are cheap relative to bonds.
Perhaps this is not the case.
An interesting article came out a week or so ago by Citizen Bernstein that provides the proper historical context:
The following discussion includes a personal anecdote which may be familiar to some readers. Nevertheless, we repeat it here because it is essential to my argument.
These events occurred during 1958, when I had been a practicing investment counsel for seven years. The economy had peaked out late in 1957 and was heading into recession at the turn of the year. By the second quarter of 1958, real GDP was declining at a shocking annual rate of 10.4% (due mostly to slashes in business investment). The recession came to an end during the final quarter of 1958, but this episode's sharp decline and brief duration were not its most important characteristics. The historical significance lies elsewhere.
During this recession, the rate of inflation continued to be positive, on both a quarter-to-quarter basis and figuring year-over-year. Indeed, during the steepest part of the decline in real GDP in the second quarter of the year, the CPI was rising at an annual rate of 3.2%, not far from the 3.4% rate at the business cycle peak in 1957:4. Rising inflation during a recession was unprecedented. Weak business conditions in the past had always been associated with deflation, not inflation. During the preceding recession of 1954, the price level had been essentially flat and then declined from 1954:3 through 1955:3.
These extraordinary events had an even more extraordinary echo in the capital markets. In the second quarter of 1958, the dividend yield on stocks was 3.9% and the yield on 10-year Treasuries was 2.9%. Three months later, dividend yields were down to 3.5% while Treasuries had climbed to match them at 3.5%. The next three months made history, as stock prices kept rising and pushed the dividend yield down to 3.3% while bond prices kept falling and drove the bond yield up to 3.8%. This, too, was unprecedented. The two yields had come close in the past but had always backed away at the critical moment. In 1958, they reversed their historical positions and have never looked back.
When this inversion occurred, my two older partners assured me it was an anomaly. The markets would soon be set to rights, with dividends once again yielding more than bonds. That was the relationship ordained by Heaven, after all, because stocks were riskier than bonds and should have the higher yield. (Our next few years?- AM) Well, as I always tell this story, I am still waiting for the anomaly to be corrected. (And that is what has just occured - AM)
As investors pondered this upside-down yield spread after 1958, two explanations (rationalizations?) began to circulate. First, the vigorous recovery from the 1958 recession had demonstrated that investors could finally put to rest the widely-held expectation of an imminent return of the Great Depression. Truly, a New Era had dawned. Second, as a corollary of the first, the notion of growth stock investing was beginning to take hold. My own article, "Growth Companies versus Growth Stocks," which had appeared in the Harvard Business Review in 1956, had attracted widespread attention - it put my name on the map for the first time. In addition, T. Rowe Price's case for growth stock investing was finally gaining respectability. Growth justified dividend yields below bond yields, because the dividend flow could increase over time while bonds were a fixed-income investment.
As I recount this story today, I am beginning to wonder whether my older partners might have had something on their side after all. The anomaly is now closer to reversing itself than at any time since 1960-1962 when - as at present - 10-year Treasury bonds were yielding less than 4%.
In the unlikely event that the difficulties the economy is facing at this moment are about to melt away, stocks will probably continue yielding less than bonds. On the other hand, if the this deteriorating financial and economic environment persists, or if conditions should become even more alarming, stock prices will fall further and Treasury bond prices will continue to rise. Then a thunderbolt would strike: my partners' forecast of an anomaly in 1958 would turn out to be valid as dividend yields revert to tradition and rise above bond yields. A fifty-year relationship would be thrown into reverse.
In that case, where was the anomaly - in 1958 or in 2008? Are there in fact any rules to define the basic relationship between bond yields and dividend yields? We see no clear answer to these questions.
A profound philosophical dilemma is present here. The yield inversion in the spring of 1958 taught me a lesson I have never forgotten: anything can happen. Just because a relationship had held since the beginning of time is no reason to believe it would also hold until the end of time. Black swans lurk behind every shadow, and we should always be prepared for unimaginable outcomes - unknown unknowns. My older partners may have been mistaken for half a century when they confronted an unknown unknown in 1958, but even a time span of fifty years was no guarantee they were going to be mistaken unto eternity. I, for one, shall not be surprised if the inversion is reversed in the near future, nor shall I expect that reversion to last into the indefinite future.
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