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Columnist Chris Farrell says a 50-year pricing "aberration" may finally be correcting as investors again grow wary of equities
Remember the movie Back to the Future? A teenager hurtles back several decades in a DeLorean time machine to the 1950s, where he meets his father, mother, and other familiar adults when they were still in high school. It's a delightful tale that wonderfully captures the teen culture of the decade, from dates at the soda shop to the emergence of rock 'n' roll. Long-time Wall Street professionals must feel that they're living through their own version of Back to the Future. This time the tale is confusing and nerve-wracking, rather than wryly amusing. In large part, the stress reflects uncertainty over the message in the changing relationship between the stock dividend yield and the government bond yield. Not that the Street is about to see the return of elevator operators, roll-top desks, and office cigars, as in the 1950s. It's that during the recovery from the short, sharp contraction of 1958 (real gross domestic product had plunged at a more-than 10 percent annual rate by the second quarter of that year), dividend yields on stocks fell below the yield on long-term Treasuries for the first time—and stayed there. For instance, in the second quarter of 1958 the dividend yield on stocks was 3.9 percent and the yield on 10-year Treasuries was 2.9 percent. Over the next 6 months the dividend yield declined to 3.3 percent and the government bond yield rose to 3.8 percent. In Against the Gods: The Remarkable Story of Risk, the late Peter Bernstein recalls that his Wall Street partners, veterans of the Great Crash, assured him over and over again that the shift in the traditional relationship between stock yields and bond yields would soon reverse. It has taken about half a century for the market "aberration" to revert. Falling Stocks, Greater Yields
Specifically, the dividend yield on the Dow Jones industrial average is 2.81 percent vs. 2.48 percent on 10-year Treasuries. The dividend yield of 2.13 percent on the S&P 500-stock index, a broader market gauge, remains below the 10-year Treasury yield but the gap is narrowing. The yield differential is currently at 44 basis points (a basis point is one one-hundredth of a percent) vs. an average of 107 basis points in June, and 202 basis points in April. The first time that the dividend-bond yield relationship of the past half century got reversed was on Nov. 18, 2008. While that didn't last long, the dividend yield is once again climbing with the recent fall in stock prices. It made investment sense before 1959 that stocks yielded more than bonds. The old-timers didn't need modern portfolio theory to tell them that stocks are riskier than bonds. Stocks represent the uncertain returns to entrepreneurship while a bond is a contract that lays out the terms for paying back the borrowed money on a regular schedule. Stocks are also riskier than bonds because when a company encounters financial trouble, bondholders have first dibs on corporate cash flows while shareholders carry the brunt of any losses. Little wonder that until 1959, public companies found they had to pay a hefty yield to attract equity investors. What changed? Bernstein surmises that two powerful forces came into play. Investors were accustomed to deflationary bouts during downturns. Most economic and market prognosticators expected deflation during the 1957-58 recession. (Memories of the Great Depression and its accompanying deflation were still strong.) Yet, in a sharp break with previous history, prices rose during the 1957-58 recession. The experience marked a major turning point in investor expectations about prices. The cost of living had risen only two-tenths of a percent annually from 1800 to 1940 and prices had actually declined on 69 occasions. Yet from 1941 to 1959, inflation had averaged 4 percent a year and prices declined only once. Inflation was the price movement of the new economy.
The Demographics of Deflation
It was also an era of strong economic growth and technological innovation. The auto and housing industries boomed, the chemical and pharmaceutical industries thrived, and the Go-Go years weren't far off. The combination of higher inflation and stronger growth expectations drove bond yields far above dividend yields. "Amazing? Not when the experience of 1958 had confirmed that the deep deflationary depressions of the old days were gone forever," Bernstein wrote in a 2005 newsletter. "Now investors could buy stocks for growth, for the long-run, to hedge against inflation, and not just for buy-low, sell-high." Fast forward to today. It almost appears to be the mirror image of 1959. There is serious discussion about the prospect for a deflationary downturn. The core consumer price index—the CPI minus volatile food and energy—was up a mere 0.9 percent year-over year during July, matching the smallest increase since 1966. The outlook for growth is also subdued, with households struggling to pay down debts and government facing the need to put its fiscal house in order. And where the Baby Boom generation's onset powered economic growth in the early postwar decades, the same generation's aging could weigh on the economy in the decades to come. "Demographics are the rarely acknowledged 800-pound gorilla," says Robert D. Arnott, chairman of Research Affiliates. "Fewer working-age people will result in lower [gross domestic product] growth." It's too early to say that the "aberration" of 1959 has reversed itself for the long haul. The ominous combination of slow growth and deflationary pressures has pushed bond yields down to very low levels. A survey of stock and bond market history also suggests that when inflation is the primary price force, the dividend yield will be below bond yield; when deflation rules, the opposite relationship holds. Certainly it's hard to see much gain left in bonds after the latest flight to safety. Meanwhile, the same combination of forces suggests that it will be tough for many companies to find good investment opportunities for their cash. Managements may well have to offer higher dividend yields to entice investors in the future. With a generation of investors burned by the dot-com bust, the credit-crunch bear market, and the disappointing experience of a decade-long return on equities of -0.95 percent, it may take higher dividend yields to entice them back into the equity fold.