Obey the Yield Signs?

Hey everybody, here's an update:

In my previous post, I wrote that it would be prudent to continue avoiding the market. Of course, as if on cue, the stock market has now rallied 18% (as measured by the S&P 500) over the four trading days since that post was published.

I'd like to make two points about that prediction:
(1) I still expect that the market will pull back, and anticipate that the market will soon give back much, if not all, of the past few days' gains.
(2) My advice to avoid the market was simply a Jedi mind trick, designed to move the market higher. Apparently, it worked very well. Very impressive, indeed.

To me, today's most interesting event was the downward move in interest rates on U.S. Treasury securities. Prices and yields (rates) move in opposite directions, so a decline in rates means that the price of Treasuries continues to rise. What we have here is a classic "flight to quality." With investors increasingly nervous about the stock market, and especially skittish about investing in corporate debt, we've witnessed a tidal wave of money flowing into the relative safe haven of debt issued by the U.S. government (Treasuries). Today, the yield on the benchmark 10-year Treasury note closed a shade below 3.00%, marking the lowest yield on that security in fifty years.

The current yield on the 10-year Treasury looks even lower when compared to the average dividend yield on the S&P 500. About a week ago, Bloomberg news was reporting that the dividend yield on the S&P 500 had surpassed the yield on the 10-year Treasury for the first time since 1958. Actually, their analysis is somewhat flawed, as they were comparing the current yield on the Treasuries with the 12-month trailing dividend yield on the S&P. Considering how many companies have cut their dividend payouts in recent months, it's a pretty safe bet that the S&P 500 stocks, as a group, will pay out far less in dividends in the next 12 months than they did over the past 12 months. A more pertinent analysis would've used the current or anticipated yield on the S&P. Now, even by that measure, the S&P 500's dividend yield is higher than the current yield on the 10-year Treasury note.

On the surface, this is an extremely bullish signal for stocks. For those who are a bit more exotically inclined, it's probably a good time to short the 10-year Treasury (betting on higher yields), while buying stocks. This strategy assumes that the Treasury yield/S&P 500 dividend yield relationship will move back toward its more normal level via a decline in Treasury prices and a concurrent increase in stock prices. Over the long term, that's probably how it will play out. However, there are a couple of things to note:

(1) Any forward-looking analysis of the yield on the S&P 500 must take into account the high likelihood of significant cuts in dividend payouts. Simply applying a 20% haircut across the board results in a much more "normal" Treasury yield/dividend yield relationship.
(2) At the risk of sounding like one of these "we're-now-entering-a-new-era-in-the-markets" people, perhaps we've turned the clock back. Way back. According to noted stock market historian and author Peter Bernstein, prior to 1958, the dividend yields on common stocks were always higher than were the yields on government or highly-rated corporate bonds. The thinking was that investors demanded a higher regular cash payout on stocks vis a vis bonds, as they were the riskier security, based upon the greater historical variability (measured by standard deviations from the mean) of their returns. In other words, investors demanded their equity risk premium in cash, as opposed to higher expected capital returns. That relationship flipped in 1958, and has remained that way for 50 years, as investors measured stocks' greater potential for price appreciation as the primary component of their anticipated total return. While I doubt that the current, "inverted" relationship will persist for very long, perhaps we really have come full circle, and for the foreseeable future, stock prices will remain depressed enough that stocks will yield more in dividends than Treasury instruments pay out. Perhaps years from now, students of the financial markets will view the years from 1958-2008 as a curiosity.

Who knows, maybe it's time to dust off the old dividend discount model?

Again, I think that the current relationship is a mere blip on the radar screen. However, it might just represent one of the first major buy signals we've got on this market, so it bears watching.