Trading Nation

By this measure, stocks are a crazy bargain

The market’s yield mystery
The market’s yield mystery

Before you lie two doors, and behind each lies a prize. Behind door No. 1 is a promise from the U.S. government to give you $1.90 each year for the next 10 years. Behind door No. 2 is a vague commitment from America's biggest companies to give you $2.25 in the next year, more the year after that, more the year after that and so on.

Oh, and if you pick door No. 2, you also get a set of tiny pieces of America's biggest companies — a bonus prize that has tended to increase in value by 7 percent every year.

Which door will you choose?

This is a simplistic version of the decision facing an investor trying to decide between allocating the marginal hundred dollars to a product that tracks the or to a 10-year Treasury note.

While the best decision will obviously depend on the investor's market expectations and financial circumstances, choosing door two — stocks — has actually gotten a bit easier lately.

In the modern era, the 10-year Treasury yield has generally been higher than the S&P's dividend yield. The rationale is that stocks offered the possibility, if not the outright expectation, of capital appreciation, while bonds hold no such opportunity if held to maturity.

For instance, 15 years ago, the dividend yield granted by the S&P 500 over the prior 12 months was 1.4 percent, with about 1.5 percent expected over the following 12 months. This as the 10-year Treasury yield sat a touch below 5 percent.

On Monday, the 10-year yield was below 1.9 percent, while the S&P 500 dividend yield over the past 12 months has been 2.1 percent, with about 2.3 percent expected over the next year.

This is mostly a story of the plunge in Treasury yields, which has come as dividend payouts have crept higher. Still, it is striking to see the S&P's dividend yield outpace Treasury rates.

This development, combined with the high likelihood of dividend increases and the relatively small dividend cuts in times of crisis, convinces Convergex strategist Nicholas Colas that "stocks still look attractive versus bonds."

To provide some context, one rudimentary way of valuing stocks is the so-called Fed model, which states that the market's earnings yield (earnings divided by price, or the inverse of P/E) should be equivalent to the 10-year note yield. This earnings-to-price ratio (at about 6 percent) is so high compared to Treasury yields that the mere slice of S&P 500 earnings that are returned to investors in the form of dividends itself dominates the Treasury rate.

While this may be viewed as a sign to buy stocks, another possible conclusion is that investors have become highly pessimistic about how future stock market returns will compare to their long-term average.

Dividend yields have generally been lower than bond yields throughout all of recent market history, but "if you go back to the '20s, people used to consider stocks to be more risky, and therefore required a higher dividend yield than they did on bonds," pointed out Boris Schlossberg, strategist at BK Asset Management, in a Thursday "Trading Nation" segment.

In some small way, perhaps that logic is taking root once again.