A popular method for determining whether equities are cheap is to compare the stock market’s dividend yield with the yield on long-term government bonds. Using the amount of dividends paid by companies in the S&P 500 index during the past 12 months, the dividend yield is currently 3.22%. Meanwhile a ten-year treasury yields 3.75%. The following is a historical look at how dividend yields and long-term treasury yields compare.
Currently, the spread is as tight as it has been since the early ’60s. Does this mean stocks are cheap relative to treasuries? Or is it likely that going forward stocks will yield more than treasuries as was the case for most of the period before 1958.
Treasuries have zero default risk, but plenty of inflation risk since the amount of the coupon is fixed. Stocks, on the other hand, have little inflation risk (because companies can increase profits in inflationary conditions), but carry default risk.
During periods of high monetary inflation, where the value of money is losing value at a rapid pace, the market will assume that inflation will continue to be very high in the future and demand a higher yield from bonds than from stocks to compensate them from future loss of purchasing power. At the other end of the spectrum are periods of deflation when the money supply contracts. Deflations cause corporate profits and dividends to decline in nominal terms, though they may increase in real terms. Therefore, expectations of deflations usually result in stocks having higher yields than treasuries.
Independent of inflation or deflation, the economy could be growing or contracting. Over long periods of time the economy usually expands. Ignoring any effects from changes in the money supply, investors will be willing to accept lower dividend yields than treasury yields because dividends are likely to increase over time. On the other hand depressions, which are economic contractions that last for many years, can increase the risk of bankruptcy causing investors to demand greater yields from stocks than from treasuries.
Combining the effects from monetary inflation and economic growth on treasury and stock yields give the following table:
I have inserted question marks for deflationary economic growth which characterized most of the 19th century when corporate profits steadily increased in real terms, but not necessarily in nominal terms; during such times there should be no significant difference between treasury and stock yields. Also, there should not be much of a difference in yields during highly inflationary depressions because it is not clear whether businesses can increase profits in nominal terms.
The table does a good job of explaining why dividend yields exceeded treasury yields during the time frame from 1871 to 1957 if one considers that this was a mostly disinflationary period punctuated by a couple of deflationary depressions. Consider that during this entire period of 87 years, inflation, as measured by the CPI, increased by 128% and corporate earnings rose by an average of 5.2% annually.
But since 1957, a period of just 50 years, the CPI has increased by 634% and corporate profits grew by an average of 7.9% annually. Thus, it should be of no surprise that since 1957 investors have demanded greater yields from treasuries than from stocks when the rate of inflation has been so high and there was not a single depression. Dividend payouts steadily increased throughout the period except for only a few short-term reductions.
So to form an opinion on whether stocks should yield more than treasuries one needs to know if the economy has entered a period of inflation or deflation and if a depression will be avoided. It is my belief that the US has entered a depression, where real earnings will decline and not recover for several years. If the Fed prints enough money and creates substantial inflation, earnings could bottom in nominal terms in 2010 at the earliest at which point I expect treasuries to yield more than stocks.
Until then I expect the depression to be disinflationary, rather than a deflationary because the government is preventing any significant bank failures which is a necessary condition for deflation. Although asset and consumer prices are declining, this is not deflation; instead it is a reflection of a drop in the velocity of money as individuals and businesses hoard cash. So if indeed this is a disinflationary depression, I expect the difference in yields between treasuries and stocks to diminish over the next year.
Japan offers a recent example of a disinflationary depression and as can be seen in the chart below the yield on Japanese stocks exceeded the yield on long-term government bonds during a significant part of the past two decades.
I am expecting similar results in US markets and would not be an aggressive buyer of equities until they yield more than treasuries.