Why History Says Stocks Are the Best Buy Right Now

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 (Nasdaq: AAPL  ) , Google (Nasdaq: GOOG  ) , and Cisco (Nasdaq: CSCO  ) -- pay no dividends at all. The slow-growers -- like Altria (NYSE: MO  ) , Verizon (NYSE: VZ  ) and Consolidated Edison (NYSE: ED  ) -- are where you find yield. That was unheard of 60 years ago.

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.

Fool contributor Morgan Housel owns shares of Altria, Verizon, and Edison. Google is a Motley Fool Inside Value recommendation. Google is a Motley Fool Rule Breakers pick. Apple is a Motley Fool Stock Advisor choice. The Fool has written calls (bull call spread) on Cisco Systems. The Fool owns shares of Altria Group and Google. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 10, 2010, at 5:30 PM, Mstinterestinman wrote:

    I agree and the averages are trading at roughly 12 times earnings far from exspensive just to get to a rough fair value calculation s@p would have to hit 1200 by years end.

  • Report this Comment On September 10, 2010, at 5:58 PM, asutin56 wrote:

    I just finished reading The Intelligent Investor and learned an immense amount from it. I highly recommend it for anyone interested in value investing.

  • Report this Comment On September 10, 2010, at 6:34 PM, mtracy9 wrote:

    "I made by far the best buys I've ever made in my lifetime in 1974. And that was a time of great pessimism and the oil shock and stagflation and all those sorts of things. But stocks were cheap." --Warren Buffett

    http://shouldersofgiantsinvestor.com

  • Report this Comment On September 10, 2010, at 7:00 PM, knighttof3 wrote:

    Where are my props? :-P

  • Report this Comment On September 10, 2010, at 7:02 PM, knighttof3 wrote:

    Hay, I said that! 4 days ago, commenting on your article "Chill out..."

    "When bonds yield less than stocks, that's the time to BUY stocks!"

    Dude, where are my props?

  • Report this Comment On September 11, 2010, at 9:24 AM, FutureMonkey wrote:

    Morgan, I'm glad you cautioned patience. One of the things that folks new to value investing need to learn is that just because you recognize the value in an individual stock or the broad index and expect outperformance, doesn't mean that the market is right behind you. Too often investors with short term gains on their mind abandon a stock that hasn't budged or even gone down relative to the market in spite of it's unrecognized value. Impatience and disappointment can undermine sound portfolio behavior.

    i.e. just because dividend yields exceed bond yields does not mean the market is going to pop up in the next 12 months. remember 1947-1955 was a 7 year period where dividend yields exceeded bond yields and a lot of the returns on market value (vs dividend) made between 1955-1965 not 1947-1955. I'm still only buying stocks in my long horizon retirement portfolio and protecting capital in my 6-month emergency portfolio. Most portfolio wealth accumulation comes from disciplined money saved every month rather than dramatic leaps in the market on a single deposit made in 1955 or 2010

  • Report this Comment On September 11, 2010, at 11:54 AM, jrj90620 wrote:

    Follow the Fed.They are debasing the currency so that means a lower Dollar and higher real assets.This mania for Dollars and bonds isn't going to end well.

  • Report this Comment On September 11, 2010, at 2:04 PM, thunderboltnova wrote:

    Problem is no one knows what future earnings will be with a huge generation heading towards retirement. To compare Buffett to 1974, the dow would have to crash to 4,000 to find such a buy. Warren Buffett was just lucky but he's been pretty lucky over all his whole life despite some mistakes he made.

  • Report this Comment On September 11, 2010, at 4:14 PM, nietzschesport wrote:

    As Edmond de Rothschild said in April "Europe’s debt crisis will cause a temporary decline in equities, providing investors chances to buy."

    And here's something from Stifel Nicolaus--

    Did you know that the "Stock Market Composite going back nearly two centuries—current performance is at low levels only seen during the Great Depression?

    The negative news flow keeps many investors on the sidelines waiting for sunnier days, while those who believe that what goes down eventually comes back up may see an opportunity to snap up equities at bargain prices. " See the charts

    The research done by Stifel Nicolaus actually deals with facts, unlike the mumbo jumbo touted by the Elmer Gantry's of the Stock Market World with visions of hindenburgs, sunspots, icecaps and the crucifxion.

    http://nietzschesportfolio.blogspot.com/

  • Report this Comment On September 12, 2010, at 10:25 AM, scanlin wrote:

    The best way to play dividend payers right now is to write out-of-the-money calls against them every month. You can usually get 0.5%/month and still leave yourself 5%+ upside potential (for a 4-week option). Adding 5-6%/year to a portfolio of dividend payers is a good idea in these times of super low bond rates.

    http://www.borntosell.com

  • Report this Comment On September 12, 2010, at 5:37 PM, rightisright wrote:

    @mtracy9 - We didn't have a COMMUNIST as president in 1974 either.

  • Report this Comment On September 12, 2010, at 7:07 PM, 11x wrote:

    I don't think it's so much that stocks are cheap as it is that bonds are paying pitiful yields.

    It would be different if bond's yields were within historical averages and stock yields were much higher than historical averages. However, bond yields are at historical lows and stocks are within historical averages. This suggests to me bonds are NOT a buy, not necessarily that stocks are a buy.

  • Report this Comment On September 12, 2010, at 7:32 PM, ChrisBern wrote:

    @11x -- you are 100% correct. Comparing stocks to bonds will not tell you whether or not stocks are cheap or a good buy--it will just tell you which is preferable to the other. PE10 (CAPE) shows stocks are about 20% more expensive today than their historical average. Do I feel 20% more optimistic about the market today than during the average investment period? Not even close. Or asked another way, what's the average actual return when buying stocks at a CAPE of 19.x, say over the following 10 or 20 years? I would guess it's not very high. I'd prefer to wait and buy stocks when they're fairly or even generously priced, which they're not today.

  • Report this Comment On September 13, 2010, at 6:59 AM, Gregeph wrote:

    Good article. Perhaps the most important fact in favor of equities is how attractive their yield is in comparison to bonds. If you are interested, I track and regularly update a number of related metrics on my blog: 1) S&P 500 Yield vs. 10 Year AA Corporate Bond Yield, 2) S&P 500 Yield vs. 10 Year U.S. Treasury, 3) Total U.S. Market Cap / U.S. GDP – (This is Buffett’s favorite market valuation metric.) and 4) S&P 500 Price / Peak Earnings. http://gregspeicher.com/?page_id=123

  • Report this Comment On September 13, 2010, at 10:08 AM, reeshau wrote:

    @rightisright - You're correct; in 1974, we had a CROOK.

  • Report this Comment On September 15, 2010, at 12:57 PM, gimponthego wrote:

    You (all) are way over my head. However, Im an opportunist and hope one or two of you might comment on a couple of the stocks I've purchased for dividends primarily...

    MO / YUM / NLY / and EMC. Do any of these fall into the category you're discussing? Many Thanks! John

  • Report this Comment On September 17, 2010, at 4:43 PM, robertcgray wrote:

    Maybe security buyers are wising up and are remembering that without a dividend/yield all they are holding is a SPECULATION, with nothing underpinning it but the "greater FOOL". And greater-fools have become hard to come by and if you connect the dots for America's future and see a fairly flat future GDP, then greater-fools are pretty gone for a generation to come. In that scenario, dividends are king. And a few retail security buyers may have also noticed that the alternative uses of corporate funds - excessive executive compensation (omitted from your list), growth-at-all-costs, poorly thought through acquisitions, and self-serving stock buybacks - are all very shareholder unfriendly (despite what icons - Steve Forbes and Warren Buffet frequently claim). Again one in the hand (dividends) are worth two in the bush (still in the hands of management). Welcome to rational behavior again!

  • Report this Comment On September 17, 2010, at 6:49 PM, mitchjl wrote:

    Speaking of dividends,i Suggest MLP, pipe line stocks that are paying a solid 10% on the average.I also like REIT stocks, CIM,AINV,ANH and NLY paying on an average 15%. PDLI a Bio Pharma Drug Company paying 19% and some times an additional year end dividend.

  • Report this Comment On September 17, 2010, at 11:49 PM, jwaymoo wrote:

    robertcgray , you are exactly right! The value of an investment is determined by its future income stream, whether that investment asset is in the form of stocks, bonds, or commercial real estate. Irving Fisher, considered by many to be the greatest American economist of the first half of the 20th Century, explained this in his landmark book published in 1906, The Nature of Capital and Income; Jeremy Seigel (Professor of Finance at The Wharton School) made this assertion in his book, Stocks for the Long Run, first published in 1994 and now in its fourth edition. The federal tax code creates a dividend paradox as hypothesized by Franco Modigliani and Merton Miller in classic journal articles – because dividend payments are not deductible as an expense, but interest payments on bonds and bank loans are deductible, firms can reduce the combined corporate and individual taxes by buying back shares rather than paying dividends (this is the double taxation problem with respect to dividends, creating economic inefficiency). The federal tax code further encourages speculation by having a much reduced tax rate on speculative gains (also known as capital gains). The obviously excessive executive compensation is often tied to incentives based upon share price rather than income paid to owners (i.e. dividends). The result of the tax code flaw is over-leveraged, higher-risk firms run by over-paid managers whose first priority is enriching themselves rather than adequately compensating the firm’s owners with dividends, which creates the Wall Street Casino mindset that winners are determined by placing bets on short term stock price moves.

  • Report this Comment On September 18, 2010, at 11:22 AM, nicklukecal wrote:

    iwaymoo and robertcgrey, Thank goodness for your insights. They are spot on. Please work however you can to spread your word or effect a change. In the meantime, stop pining for Shangri-La and trade the chart in front of your eyes. Buy up trending stock and short down trending stock. You can breathe Hopium all you want but don't go broke in the meantime. I'm sorry but in the current environment, technical analysis trumps fundamental analysis, and by your own logic will do so for a long time to come!! Buy and hold is DEAD.

  • Report this Comment On September 18, 2010, at 5:21 PM, magoo2pp wrote:

    MSB has been a great Div play, and actually you make money on the stock. I just bought this at 17 and change in the may selloff, today at 33 plus. Plus paid me >10% div July 28th! So almost a double, and 10% on that!

  • Report this Comment On September 19, 2010, at 9:33 AM, robertcgray wrote:

    NickLukeCal - It is all good! I certainly agree that today's activity is 99% a trader's/speculator's market. B&H is not really dead, it just is so boring to most people it has the appearance of death. MLP's, as others have noted in these comments, are great dividend plays - as are a variety of off-shore securities and funds. You can get yield and growth in some geos. Electric utilities grow at 2X GDP in emerging markets - what is not to like? Finally, if you are really a B&H INVESTOR, valuing the time-mediated income stream - all this up and down volitality is of little interest - then the down market is your best-friend - the ability to buy income on the cheap!

  • Report this Comment On September 19, 2010, at 9:39 AM, robertcgray wrote:

    I'm thinking about making a YouTube video about the INVESTING/SPECULATION distinction - ask the question to a bunch of people - watch them work their way around the question. Especially fun with the financial services types. String pieces of it together, along with the correct core definition. Pretty doable with my iPhone 4, etc. Very few people get the answer anywhere near correct - and the wrong answers should be so embarrrasing to people - but are not. I love asking people pitching being my financial advisor the question - only one ever got it correct. Not sure many people care about this.

  • Report this Comment On September 19, 2010, at 1:56 PM, KZMike wrote:

    @rightisright. . . since you shared your deep & well thought out analysis of the President and you feel 'justified/secure' in its accuracy as your investment analysis, I am sure you would not mind sharing some of those insights with us as well>>>>?

  • Report this Comment On September 22, 2010, at 12:11 PM, cpscmlvr wrote:

    There are two additional important reasons that should be considered when looking at current dividend vs. bond yields:

    The first is that much of the yield from stocks have historically come from increases in share price. As pessimism pervades the market, investors are no longer willing to pay a premium for anticipated growth and must get their return from higher dividend yields.

    The second is uncertainty over the capital gains tax rates. Principal growth in stocks historically have received favorable tax treatment, thus favoring returns due to reinvestment and growth in the value of the Company. In recent years, dividends have enjoyed similar tax rates. With uncertainty over whether favorable tax treatment will continue beyond 2010, investors look at dividends on a tax adjusted basis the same as interest payments on bonds and require a higher pre-tax yield.

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