A bullish indicator gives investors more confidence to buy or hold a position. There are many variables to track when making an investment decision. However, this bullish indicator has been flashing green since 2Q2020 and is still flashing green today in 2021.
As I was updating my post on helping people decide whether to pay down debt or invest, I was reminded about the S&P 500 dividend yield versus the 10-year Treasury bond yield.
Take a look at the chart below that shows the ratio of the S&P 500 dividend yield to the 10-year treasury yield. The ratio skyrocketed because the 10-year bond yield has plummeted, yet the S&P 500 dividend yield has remained relatively steady between 1.8% – 2%.
A Bullish Indicator Flashes Green
The first time the S&P 500 dividend yield yielded more than the 10-year Treasury yield was back in 2009. As we now know, buying stocks in 2009 proved to be a phenomenal time to buy stocks (and real estate).
When the above chart was published on 4/30/2020, it also proved to be a fantastic time to buy the S&P 500. If you did not read my post on March 18, 2020 calling the stock market bottom, you could have paid attention to the S&P 500 dividend yield to 10-year yield ratio. On 4/30/2020, the 10-year bond yield was at ~0.65%, which means the S&P 500 yield was at ~2.1%.
Today, the 10-year Treasury yield is at ~0.85% and the S&P 500 dividend yield is at ~1.8%. Therefore, the ratio has come down to 2.1 from over 3. Despite the lower ratio, anything above 1 is still considered a bullish indicator.
Why Is It Positive When The S&P 500 Dividend Yield Is Higher Than The 10-Year Treasury Yield?
As a stock investor, it's always important to pay attention to the 10-year Treasury yield. The 10-year Treasury yield is the risk-free rate of return and your opportunity cost for not owning a safe asset instead.
When the S&P 500 yield is higher than the 10-year Treasury yield, investors start forsaking investing in Treasuries because the returns are relatively less attractive.
A Total Return Boost
Instead of just getting a return equal to the 10-year yield, why not take more risk? S&P 500 investors can earn a yield higher than the 10-year yield and potentially more upside through index appreciation.
A stock investor's main goal is to see capital appreciation. However, as the dividend yield gets relatively more attractive, a stock investor also starts seeing the dividend yield as a total return boost.
For example, let's say an investor expects to make a 10% return on Apple stock in one year. With Apple's 1.5% dividend yield, the investor's total return is expected to be 11.5%.
A Downside Buffer
Instead of viewing the S&P 500 yield as a total return boost, investors can also view the S&P 500 yield as a downside buffer.
For example, let's say you own the S&P 500 and are afraid of a 10% decline one year. If the S&P 500 is yielding 2% and does decline by 10%, your total loss is 8% instead of 10%.
As someone who doesn't have a steady paycheck or a working spouse, I view stock dividends more like downsides buffers. When stocks are crashing, I find comfort in the dividend to keep passive income cash flow alive.
For capital appreciation, I simply allocate capital to growth stocks that often don't pay a dividend e.g. Tesla.
A Stock Dividend Is Not Free Money
Some dividend stock investors erroneously believe that a dividend yield is free money. The reality is that every time a company pays a dividend, the value of the company temporarily declines by the amount of the dividend.
The dividend payment comes from the company's cash holdings. Therefore, a reduction in cash reduces the company's book value. To understand the concept better, it helps to pretend you are the owner of a business looking to sell.
Let's say your company has $1 million in cash and a business worth $5 million based on 5X operating profits. You have a buyer willing to pay $6 million for the company.
But if your company decides to pay a dividend to existing shareholders that drains the cash account to zero, then the buyer will rightly only want to pay $5 million at most.
If the publicly-traded dividend stock has a history of paying dividends or increasing its dividend payout ratio, then the stock will likely recover soon after paying out its latest dividend. If the dividend payment is perceived as more one-off or unsustainable, the stock will tend to trade to trade at a lower price due to the loss of cash.
How much of a company's earnings are paid out is never guaranteed. The hope of all stock dividend investors is that the company continues to generate ever-higher profits and pays ever-higher dividends.
Once a company lowers its dividend payout ratio or cuts dividends, especially if the company is considered an ex-growth dividend company, the stock is likely to languish for a very long time, e.g. AT&T.
Another great stock market indicator is the high-yield corporate bond spread. If the spread is low, it means bond investors believe corporations are in good health. IF the spreads are blowing out, it means bond investors are more nervous about corporations.
S&P 500 Earnings Yield vs. The 10-Year Yield
Another good comparison is to estimate the S&P 500 earnings yield to the 10-year yield.
Let's say the S&P 500 is estimated to earn $165 / share in 2021. At 3,638, the S&P 500 is trading at ~22X forward earnings. The S&P 500 earnings yield can be found by dividing the earnings per share by the share price, i.e. $165 / 3,638. Therefore, the S&P 500 earnings yield is ~4.5%.
When you compare the S&P 500 earnings yield of 4.5% to the 10-year bond yield of 0.88%, the S&P 500 looks relatively attractive as well. Whenever the S&P 500 earnings yield is at least 3X higher than the 10-year bond yield, I'm a buyer.
Bullish Indicators Abound
As the S&P 500 marches higher, its dividend yield will decline unless corporations increase their dividend payouts. As a result, the S&P 500 dividend yield to 10-year Treasury yield will also decline. But so long as the ratio is above 1, it is still a bullish indicator.
We already know that when there's a Democrat in the White House and there is Congressional gridlock, the stock market tends to perform very well.
We also know that there are at least three vaccines with high efficacy rates that will be available to everyone within six months. These vaccines should help create herd immunity and eventually get all of our lives back to normal. As a result, corporate earnings are likely to rebound.
The federal government may even pass another stimulus package rather than continue to do nothing for the millions of Americans suffering from the pandemic. However, with no elections for a while, politicians aren't motivated. They've got their power for 2-4 years and their guaranteed paychecks.
Finally, with the Federal Reserve committed to a 0% – 0.25% Fed Funds rate until 2022+, the 10-year bond yield will likely remain depressed as well. Therefore, the S&P 500 dividend yield and the S&P 500 earnings yield will likely continue to be higher than the 10-year Treasury yield.
In conclusion, with so many bullish indicators, it's hard not to get long or stay long the S&P 500. Goldman has a 4,300 year-end 2021 target. JP Morgan has a 4,500 year-end 2021 target. And many more research houses are similarly bullish.
Sure, there will likely continue to be sell-offs. We will also have to wait patiently for corporate earnings to recover. However, I think there's a 70% chance the S&P 500 will be higher 12-months from now.
What Could Go Wrong With Stocks?
My only worry is that given this bullish investment thesis is so obvious and ubiquitous, we must be missing something. Perhaps there will be a viral mutation that makes all the vaccines ineffective. Maybe the Federal Reserve raises rates too quickly because it misreads demand. Or maybe a nuclear war breaks out.
Something bad is bound to happen. And something bad did happen in 2022! At least in a bear market it's easier to generate more passive income.
The question is whether that bad thing will cause another bear market or simply be another bump in the road. I'm willing to stay long risk assets with the majority of my net worth. Are you?
I've decided to follow my dollar-cost averaging strategy and buy any dips of 1% or more going forward.
What are some other bullish indicators you've noticed for stocks, real estate, and other asset classes? What do you think is the most bullish indicator for stocks? Join 60,000+ others and sign up for my free newsletter.