Great News for Investors: Stocks Yield More Than Bonds

Something rare and wonderful happened last week: The average dividend yield on the 30 Dow Jones Industrial stocks surpassed the yield on the 10-year Treasury bond. As I write, the average Dow stock yields 3%, while the 10-year Treasury yields 2.93%.

Why you should care
Since stocks provide the possibility of growth, investors are typically willing to pay a premium over bonds. When investors think future growth will be strong, the spread widens. When they're expecting a slowdown, it narrows.

Right now, the spread is negative. What this means is pretty straightforward, and falls into one of three possibilities:

• The market thinks dividend payouts will fall over the next decade.
• Volatility's beaten the market into submission. 
• The market is a deranged lunatic, and stocks are cheap compared with bonds.

Depending on how you look at it, this is either terrifying or fantastic news. Terrifying in that market is predicting an awful 10 years; fantastic in that it proves how utterly fear-stricken investors are.

For historical context on this issue, the best guide is Yale professor Robert Shiller's collection of market data dating back to the late 1800s. I truncated the data down to 1925-today, since markets have developed and matured so much that comparing today to the 1800s isn't terribly useful.

Digging through the data, a couple points stand out:

• Since the late 1950s, equities have nearly always commanded a spread premium, with bonds yielding 3.8% higher than stocks on average.
• The Great Depression in the 1930s is the only modern period where dividend payouts fell over various 10-year periods. From 1930-1940, S&P 500 dividends fell by roughly one-third. Dividends' average compound annual growth rate from 1925-2006 was 4.6%.

That said, today's market prices imply that the next 10 years will be the worst time for corporations since the Great Depression, and unimaginably worse than other wretched periods such as the mid-1940s and the 1970s.

The market that cried wolf
Could that happen? Sure it could. Whether you should actually bet on it happening is another question. And as hard as it may be today, I wouldn't. The last few years have been hellish, yet S&P 500 companies are paying higher dividends today than they were in 2006. Corporate America is a resilient beast.

If you think today's market is correctly predicting the future, here's a game to play: Ask yourself how often the market has accurately predicted the future 10 years hence when prices imply outlying future returns (in either direction). Or even five years hence, for that matter. Their track record is pitiful. When markets predict neverending booms or perpetual busts, they're almost invariably wrong. Try debating that.

Fear and greed control markets short-term, after all. When the spread hit negative 10.3% in 1932, the market was shouting from the rooftops that investors should flee stocks and hide in bonds. Stocks then nearly quadrupled over the next five years. When the spread hit 5.3% in 2000, the market was begging investors to go all in. You know what happened next.

If history is a guide, today's negative yield spread is a bullish sign for stocks, and bodes ill for bonds. Of course, that's exactly the opposite of what most investors have been doing over the past year, with bond inflows outpacing stock inflows by magnitudes. Past returns mixed with fear make people do funny things.

Follow the money
Want to take advantage of what the market is serving up? Consider that several members of S&P's Dividend Aristocrat Index, which S&P describes as companies "that have followed a policy of increasing dividends every year for at least 25 consecutive years," yield considerably more than 10-year Treasurys' yield of 2.93%.

Source: Capital IQ, a division of Standard & Poor's.

Gloom is rampant. Profits are at new highs. Dividends are higher most other income alternatives. Call me nuts, but it looks like stocks are a better buy today than they've been in a while.