It's looking gloomy out there. The S&P 500 is down 12% year to date, led by the financial sector, which has lost one-fourth of its valuation. Even the "best" sectors of 2008 -- consumer staples and health care -- are down year to date.
But there are two reasons why this is a great time to be invested in the market.
Add it up
Amid all the doom and gloom, one silver lining has drawn little attention: Dividend yields are the highest they've been more than a dozen years.
The recent market plunge has increased the S&P 500's dividend yield to 2.2%, its highest level since December 1995. Not even during the aftermath of the tech bubble collapse in the fall of 2002 -- when the S&P 500 traded at a paltry 815 -- did the yield break 2.0%.
The increased yield is even more impressive when you consider the following:
- 10% fewer companies paid dividends in 2007 than in 1995.
- Share buybacks have more than quadrupled since 2003.
- The $589 billion companies spent in 2007 to buy back shares is more than double the $246 billion paid out in cash dividends the same year. For example, IBM
(NYSE:IBM) repurchased $19 billion worth of stock in 2007, vs. only $8 billion in 2006. That $19 billion buyback dwarfed the $2 billion paid out in cash dividends. - Financials, which have historically been the biggest dividend payers, comprising 16% of the index but paying 25% of the dividends, have been cutting their payouts. Wachovia
(NYSE:WB) is a case in point, slashing its quarterly dividend per share from $0.375 to $0.05.
Some of our most well-known blue-chip stocks, like recent Warren Buffett investment Dow Chemical
An unexpected disparity
But high dividend yields aren't the only reason this is a great time to be in the market -- stocks are also cheaper than trusty bonds.
The 10-year Treasury bond currently yields 4%. The equivalent measure of return for stocks is the earnings yield (earnings divided by price) -- and it currently stands at 5.5% for the S&P 500.
This divergence is unusual -- and a potential boon for investors. According to renowned value investor Arnold Van Den Berg of Century Management, (whose firm returned 13% net of fees vs. 6% for the S&P 500 over the past 10 years):
The usual difference between a bond yield and stock earnings yield is about 1%. For example, if investors can get 6.3% on a guaranteed bond they are willing to accept 1% less, or a 5.3% earnings yield on a stock. The reason for this is that if you have a 5.3% stock earnings yield and it is growing at 7%, it will equal your 6.3% bond yield in about 3 years. Anytime thereafter, the stock earnings yield will increase by 7% per year.
Investors are usually willing to accept a lower yield in stocks, because of the presumption of future growth. Right now, however, investors can get that growth at a better price than bonds -- and with the added bonus of high dividend yields.
Earnings yields like this suggest the market thinks earnings are likely to fall. But I would counter that even if earnings fell, the S&P 500 still would yield almost equal to the Treasury bond rate.
A good time to buy
The combination of high dividend and earnings yields relative to bond yields means that this is a great time to buy dividend stocks.
And there are a lot of good options to research further. Energy behemoth BP
At Motley Fool Income Investor, we believe in the power of dividends to create unbeatable long-term returns. Our recommendations have an average dividend yield of 5.6% -- and an overall return of 17% compared to 10% for like amounts invested in the S&P 500.
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Fool analyst Andrew Sullivan loves dividends, but does not have a financial position in any of the stocks mentioned in this article. Dow Chemical, Alliance Bernstein, and Kimberly Clark are all Income Investor recommendations. The Motley Fool's disclosure policy pays ... well, you know.
