John Mauldin has posted an article from Peter Bernstein about the historical relationship between dividend yields and treasury yields. Prior to 1958, dividend yields always exceeded treasury yields. Since that time, treasury yields have always exceeded dividend yields.
He, correctly, I believe, ties the change to a change in the nature of inflation. From 1800 to the 1950s, the price level in the US were basically unchanged. It would go up during wars and down during depressions, but over the long term, prices were stable. Monetary and fiscal policy changes during the post World War II era changed the nature of inflation so that prices rose every year, even in recessions, and the inflation rate became more volatile.
If you refer to my stock market valuation model, expected stock return equals dividend yield + long term rate of real profit growth + expected inflation. If you look at the current spread of treasury yields to inflation protected securities, inflation is expected to be negative over the next five years, and about 1% over the next 10-30 years. While I realize there has been a market dislocation in the TIPS market, given the deflationary forces affecting the financial system today, expecting falling to flat prices is perfectly reasonable.
So if I take today’s S&P 500 value of 904, I get a normalized dividend yield of 3.2%, a long term real earnings growth rate of 1.7% and an inflation rate of 1%, for a total expected return of 5.9%, nearly 2% less than investment grade corporate bond yields, which makes stocks a less-than-compelling investment. To expect a long term return of 8%, you would need a dividend yield of 5.3%, which would imply a value of the S&P 500 of 521, or 42% below where it is today. Ouch.
If you look at the pre-1958 era, normal dividend yields were between 4% and 6% and normal treasury yields were between 3% and 5%. If we have figured out how to tame inflation, and that’s a big "if", of course, then it should be perfectly reasonable to expect a dividend yield of 5.3% from equities. In that event, then bonds are a much more compelling buy today than stocks. These types of structural shifts can take a long time to process, which would imply that the equity market is likely to grind sideways for years, slowly sapping investors’ energy. The regulatory changes that are coming to the financial sector will almost certainly curtail credit creation, which will in turn curtail inflation, securities trading and speculation.
WE ARE IN A NEW ERA. Be happy collecting interest and forget about the stock market until dividend yields are a percent or more above treasury yields.