Dividend Yields and Bond Yields

Two questions I ask myself is whether dividend yields versus bond yields are a good timing indicator for the stock market, and if so, is now a great time to be buying equities?

The chart below shows a comparison between bond and dividend yields in Australia since 2002: 

Australia

Source: unisuper.com.au

I don't currently have access to primary data via Bloomberg or similar, so this chart (and the ones below) are sourced from elsewhere on the internet, hence why they look a bit grubby, inconsistent and not completely up-to-date. No matter: the point is the average dividend yield is currently substantially greater than bond yields, and that is a somewhat rare phenomenon in recent history.

In 2002-2003 when Australian bond and dividend yields were kind-of similar, it was right before the massive equity bull market ending in 2007. Again, in 2008-2009 when dividend yields spiked well above bond yields was a fairly well-timed signal ahead of the equity market rally. Ditto for 2011-2012 ahead of the recent rally.

Here in Australia, a very common yard-stick to measure how much income the stock market can provide is to look at the big four banks. Listed below is the historical, grossed-up dividend yields:

NAB: 8.9% p.a.
ANZ: 7.8% p.a.
WBC: 8.9% p.a.
CBA: 7.7% p.a.
Average: 8.3% p.a.

The RBA Cash Rate is 2.75% p.a.

So the big banks pay over three times the cash rate.

Also note from the graph that bond yields were actually gradually increasing from 2005 - 2008 despite a big stock and property bull market. At one point late in the equity bull market, dividend yields were almost half of the bond yield.

Yeah, but...

The next chart shows bond yields and dividend yields since the 1950's in the US:

U.S.A.

Source: www.clime.com.au

Hmmm, this tells a slightly different story. It's actually been very common for bond yields to be higher than dividend yields. Part of this is probably due to the taxation of dividends in the US.  The last major time dividend yields were higher than bond yields was the 1950's. Bond yields started pushing higher in the 1950's leading to a monster spike in interest rates in the 1970's. The two and a half decade period from the mid 1950's to early 1980's was basically waste of time for stock market investors in inflation adjusted terms, unless you could trade through volatility or had the vision to invest in a struggling textile manufacturer called Berkshire Hathaway.

Note the great equity bull market starting in the early 1980's occurred when bond yields were massively higher than dividend yields.

The next chart is from an even older time period in the US:

Look at the whip-sawing in dividend yields: and we complain about current volatility! You can see the big spikes in dividend yields relative to bond yields ahead of two very big equity rallies: the Roaring 20's and the huge expansion in wealth following the Great Crash to the end of the 1950's. No wonder life looked so much fun in the early 1960's in the Mad Men series. What I now observe from the first chart of US bond v dividend yields is this was the end of an era where dividend yields outstripped bond yields and bond yields were on the march upwards.

Note that during much of this time in history dividend yields were greater than bond yields. People didn't trust equities as much back then.

Also note that from the late 1930's to the late 1950's, bond yields were in-fact increasing from historical lows, yet the stock markets continued a bull run.  

Fast forward to today.

Facts:

• Interest Rates are very low from an historical perspective.
• Dividend yields are higher than bond yields.
• Lots of money is being printed in the US.

A number of things could happen: inflation kicks in and we get higher interest rates, and/or the mother-of-all bear market in bonds) leading to an average or perhaps poor time for equities.  Lots of volatility for sure. Alternatively, stock prices could increase massively if interest rates stay the same or even meander upwards.

And that is a big generalisation. With inflation, businesses that can increase prices could do really well. Income securities with floating interest rates could do really well. Businesses that can't increase prices will do very badly.

Hence part of the reason why equity markets have rallied so hard in the last nine months and  have also come-off pretty hard as well in the last two months: people feel they have been forced into riskier assets due to low rates and have now been scared senseless out of risk when they get a sniff from the Fed that money printing may stop and interest rates might go up.

Plenty of academic studies show a negative relationship with changes in interest rates and changes in stock prices. Even then, it doesn't appear this may hold true in the short term as the charts above show. The story is more far complicated with absolute interest rates and dividend yields. Sometimes periods of high interest rates have been a great time to get into equities. Sometimes low interest rates have meant a great time to be in equities.

I was hoping to be definitive with this post.

Unfortunately I am not.

I hope this is interesting anyway.

Kristian