In the first two parts of this series, we reviewed the impact of volatility and earnings on the market. In this installment, we continue to look at unique indicators and analyze what happens to the stock market as these readings are digested by market participants. We believe examining a combination of traditional and non-traditional metrics can put the current movement of the stock market in better context. This week, we are analyzing the performance of the S&P 500 when dividend yields become materially elevated relative to 10-year Treasury yields.
We acknowledge that income investors cannot sit back and assume that dividend income from stocks will be the same as coupons from bonds during periods of economic stress because dividends are “nice to have” and companies are not mandated to pay them out. That said, when we look at the historical relationship between dividend yields on the S&P 500 and the yield on the 10-year Treasury bond, we see it is now near all-time highs. In fact, at the end of April 2020, the trailing dividend yield for the S&P 500 was 1.98 percent, while the 10-year yield was at 0.62 percent, for a ratio of 3.19 to 1.
S&P 500 dividend yield to U.S. 10-year Treasury bond
There are few instances in the last 149 years where dividend yields have been this high relative to the 10-year Treasury.
Source - RBC Wealth Management, FactSet, Robert J. Shiller; data through 4/30/20
Since 1871, there have been only 33 months, or 1.8 percent of the time, when this ratio exceeded 3x. When we take each of those occurrences and fast forward 24 months, the S&P 500’s average return was 27 percent versus the normal 24-month return of 13 percent. Importantly, the returns are positive 75 percent of the time; the biggest decline was 18 percent, while the greatest increase was 108 percent. We believe this speaks to relatively favorable upside relative to downside for those with a longer-term investment horizon.
In addition to extreme differences between dividend yields and 10-year bond yields, we also note that individual investor sentiment is currently at very depressed levels, according to the American Association of Individual Investors (AAII). In a weekly survey, AAII asks individual investors whether they are bullish, bearish, or neutral on the stock market over the next six months. Historically, when individual investors are bearish, this has been a good time to get involved in the stock market. This is empirically demonstrated in the chart on the next page, and it is a good contrarian indicator for those with a longer-term investment horizon.
American Association of Individual Investors sentiment and forward S&P 500 returns
SD=standard deviation; Source - RBC Wealth Management, Bloomberg, FactSet; data through 4/30/20
In our analysis, we reviewed the monthly data back to 1998 and measured the forward 24-month return for the S&P 500 by different standard deviation bands. In aggregate, we found the average return over a 24-month period for the S&P 500 is 10.9 percent and the average bullish minus bearish reading is +7.8 on a rolling three-month basis. Currently, the bullish minus bearish reading is sitting at -13.8 and is more than one standard deviation below normal, meaning investors are rather bearish. The average return for the S&P 500 when investor sentiment is this bearish is 23.2 percent, almost twice the average return for all periods.
While each time period is different in the equity market and equities should be viewed as risk capital, these indicators help provide a road map for those looking for a more optimistic outcome in the market. Based on our work, investors with a multiyear time horizon and risk capital may want to review their equity allocation with their financial advisor.