Bond yields have reached a crucial inflection point since the election that could spell bad news for the stock market with the 10-year notes' 2.5% yield now offering a more attractive return than the average 1.91% dividend yield offered to investors by S&P 500 stocks. According to the Wall Street Journal, this threatens to reverse the trend from a year ago when investors bought U.S. bonds for asset appreciation—and not yield—and bought stocks for dividend yield. Already, net inflows to dividend-heavy exchange-traded funds have slowed for three straight weeks through March 8, to their lowest level since the week ending January 18.

Treasury Yield vs. Dividend Yield

The yield on 10-year Treasuries has climbed to 2.5% as investors believe that inflation and economic growth could be around the corner if President Trump gets his way with regard to economic policy goals. The Federal Reserve has also hiked interest rates, supporting the view that bond yields ought to be creeping higher. Meanwhile, as stocks have risen to new highs, the dividend yield on the S&P 500 has effectively dropped to just 1.9%, a 60 basis point discrepancy from Treasuries.

According to the Wall Street Journal, "rising bond yields generally send a signal that the economy is healthy and that demand for goods and services is rising. But increases in long-term yields over time also stand to shift investor preferences that recently have been strongly skewed in favor of stock investments." Interest rates on government bonds have been at historic lows following the 2008 financial crisis, with the Fed keeping short-term rates close to 0% for more than eight years. Some analysts believe it was these low interest rates that fueled the bull market in stocks over the past few years—as dividend yields remained higher than 10-year yields. (For related reading, see: The 2007-08 Financial Crisis in Review.)

The reason for concern now that dividend yields have fallen below the 10-year lies in the rule of thumb that if an investment's dividend yield is greater than the treasury yield (a risk-less asset), then that investment is attractive given that the risk profile is not too high. On the other hand, if the dividend yield falls below the 10-year yield, the market may be overpriced—since if stock prices fall and dividend rates stay the same, the dividend yield will increase (dividend yield = dividend/share price). Still, according to the chart below, provided by the WSJ, bond yields did spike above the dividend yield in 2013 and 2014, without a major stock market correction.

A closely related yield measure to watch is the so called "Fed Model," which compares the stock market’s earnings yield (E/P ratio) to the yield on long-term government bonds. In theory the two yields should be the same. If the yield on 10-year treasuries exceeds the earnings yield of the stock market, stocks are overvalued since stocks must fall for the two yields to come in to line. Currently, the earnings yield on the S&P 500 is 3.75%, indicating that by this measure, stock prices can still rise—or alternatively bond prices can still fall. (For more, see: Breaking Down the Fed Model.)

 

 

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