One persuasive argument for why stocks are a better buy than bonds today is that, for the first time in over half a century, the Dow Jones's dividend yield exceeds the yield on 10-year Treasury bonds.
There's really only one way to justify this: panic-driven fear over deflation that could make the Great Depression look like a sissy. The market is saying, and saying loudly, that dividend payouts are going to be butchered over the next 10 years. By a lot. Unless you think this is likely -- and if you do, bask in your bond bubble -- there's practically no way to justify the current divergence between dividend and bond yields.
Or is there? One popular argument making the rounds comes from a group who says the past 50-some-odd years of bonds yielding more than stocks was the anomaly, not the current reversal. Their evidence seems bulletproof: Before the 1950s, stocks almost always yielded more than bonds. And shouldn't they? Stocks have a nasty tendency of blowing up, and stockholders stand second in line to bondholders, so investors are right to demand extra yield. Only from the 1950s to circa-2009 was this view thrown out the window.
If you think of markets from this historical perspective, the implications are grim. Perhaps the past 50 to 60 years was one giant equity bubble that's now fraying at the seams. Perhaps we've been fooling ourselves for generations, glued to a cult mentality that says stocks are forever and always superior to bonds, amen. With that cult dying bit by bit, perhaps we're headed back to the pre-1950s days when stocks consistently out-yielded bonds. Woe is our future, basically. That's the argument I've been hearing a lot lately.
But there's a major flaw in it. And it's a simple one: To accurately compare dividend yields over time, you have to assume that dividend payouts as a percentage of net income stay the same. But that's not even close to how history has played out.
In the 1973 version of his classic book The Intelligent Investor, Ben Graham -- Warren Buffett's early mentor -- notes an important shift:
Years ago it was typically the weak company that was more or less forced to hold on to its profits, instead of paying out the usual 60% to 75% of them in dividends. The effect was almost always adverse to the market price of the shares. Nowadays it is quite likely to be a strong and growing enterprise that deliberately keeps down its dividend payments ...
His point, of course, was that dividend payouts as a percentage of net income were falling. And that's exactly what happened. From 1920-1950, the average S&P 500 company paid out 72% of net income in the form of dividends. From 1950-2010, that number dropped to 51%. From 1990-2007, the average was 45%. Over the past year, it's down to 33%. Today, some of the most profitable and fastest-growing companies -- including Apple
More than anything, this explains why stocks consistently out-yielded bonds before 1950. Back then, stocks were essentially just high-yield bonds with variable-rate coupons. Today, companies tend to hoard net income to finance growth, acquisitions, and buybacks. It's inane to compare the two periods without adjusting for that paradigm shift.
What happens when you do? Well, if you model the past to assume that S&P companies have always paid out 33% of net income as dividends, like they do today, then prolonged periods of stocks out-yielding bonds become incredibly rare. There would have been only two such periods in modern history: from 1940-1944, and 1947-1955.
And what's neat about these two periods? They were both phenomenal times to buy stocks. In the 10 years after 1944, stocks surged 161%. In the 10 years following 1955, investors were rewarded with a 145% return -- and both figures don't include dividends.
History is pretty clear on this stuff: When stocks out-yield bonds, it's a great time to buy them. Some patience may be required, but the rewards for those patient few are invariably awesome. Today, with the average large-cap stock out-yielding Treasuries, there's little reason to think patient investors won't be rewarded like champions 10 years from now.
Ben Graham gets the last word: "The market price is frequently out of line with the true value. There is, however, an inherent tendency for these disparities to correct themselves."
Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.