In a prior article, we discussed the 80 year history of the S&P dividend yield versus the long-term Treasury bond yield.  In this article we discuss the history of the S&P earnings yield versus the long-term Treasury yield. 

This is a response to some of our readers who suggested that the earnings yield comparison would be more meaningful.  We see the point, but do not entirely agree. 

Warning:  The next section is counter-cultural and cathartic

In our view, trading pieces of paper based on how much money the company makes whether or not it gives any of it to the owners of the company is fundamentally flawed.

Yes, we know that the theory says the earnings reflect the eventual dividends, but we say that is mostly baloney –  “eventually” is far beyond any investment time horizon we think is reasonable.  The fact is, as we see it, that unless owners receive cash from their ownership, the game is an illusion at best and a scheme at worst. 

Too many executives of too many companies hide behind the theory to simply horde profits to the exclusion of the interest of owners and to the enhancement of their own egos and wealth. 

The theory has become fundamental dogma based on ivory tower academic thinking and made standard practice by executives and investment bankers who like to keep the money under their control for their own purposes.  The sales and advisory world has been indoctrinated in the dogma and has accepted it as given fact without thought or examination in far too many cases.  Those who challenge it are often seen as heretics, and ridiculed or dismissed as eccentrics.

Fortunately, equity-income investing has begun somewhat of a renaissance.  As the boomer generation retires, their necessity for income may drive them to think more about dividends and to allocate money in such a way as to force corporate management to shift policy somewhat. 

Nobody in their right mind would buy a private business and agree never to receive cash from the business, so why should they agree to own stocks and never receive cash from those businesses.   We aren’t talking about start-up companies or companies in cash squeeze situations.  Private owners take less or nothing in those cases too.  We’re talking about the companies with plenty of dough who lavish cash on executives while treating owners like Cinderella.

Investment without cash return is an illusion of wealth — a massive, global illusion that may sustain itself for decades or even hundreds of years, but someday investors will realize they are owners.  As owners they will demand a share of the cash.  If they don’t get a share of the cash they will walk and buy something else that goes generate a cash return.  Otherwise, the stock market is nothing more than a giant scheme based on the greater fool theory.

Our minority view notwithstanding, we play the game by the current rules, because we have to.  However, we tend for our own account to lean toward situations that produce dividend or interest yield, because it seems more real to us.  

We have our share of non-dividend paying positions.  We buy apparently undervalued stocks that don’t pay any or much dividend when opportunity exists within the game as it is played. 

We also believe in the tooth fairy, Santa Claus and the day in the distant future when investors will wake up and demand that they receive their fair share of the cash profits of the companies they own.  And, we believe in the day that investors as owners will stop accepting the pitch from executives that they can invest profits more effectively in the company than in the form of dividends — translation: they can create bigger companies that will pay them bigger salaries and bigger bonuses while continuing to pay little or nothing to the owners. 

Why owners of public companies accept terms completely contrary to terms they would accept in private companies is a mystery to us.  Public company owners for some reason have collectively agreed to trade their precious cash for pieces of paper that say they own the company, even though they too often receive little or no direct ownership benefits.

Whew!.  That makes us feel better.  Now we’ve said it and can move on with the game as it is played today.  We can’t change the rules, so we play by them.  We just had to call it as we see it for the record and advocate for change.

Back to normal investment discussion:

Our idealistic view of owner’s rights and needs to share in cash profits is our explanation of why we think our first article about the ratio of stock dividend yield to bond interest rates is a more interesting presentation than one based on earnings yields.  That said, here is the long term history of the ratio of stock earnings yield (yield to the company not to the owners) versus the long-term Treasury bond interest rate.

Note that we charted the 3-year moving average of the weekly figures beginning in 1927, causing the first data point to be shown as 1930.

      click image to enlarge

The most notable attribute of the earnings yield line is that while it has risen significantly from the internet bubble years, it is not yet at what would appear to be an average level, unless the peak periods are discounted as abnormal. 

The last peak was during a period of recession and stag-flation.  The prior two peaks were during  WWII and the Korean War.  So, unless we are at war and facing recession and inflation (that could be our condition today), we might not expect those peaks.  Peaks as high as those are more likely to be achieved by stock prices declining than by earnings rising with stock P/E ratios compressing.

The next most notable attribute is the recent inversion of an approximate 25 year pattern.  Since the early 1980’s, the long-term bond yield was higher than the stock earnings yield.  Recently, however, the bond yield has been lower than the stock earnings yield.  That could be a new order of things — reverting to the relationship that existed for most of the 50 years before the early 1980’s.  Or, it could be an aberration that will require bond yields to rise or stock prices to rise or a combination of both.

       click image to enlarge

Somewhere in the 1950’s the ratio of earnings yields to long-term Treasury bond yields changed.  As in our prior article on dividend yields to Treasury yields, we don’t know why and would like to find the answer. We’re still looking for a market historian with some good ideas on that story.

As you might expect, earnings yields have had a more volatile history than dividend yields.  Note that while we think corporations are too stingy with dividends, we strongly endorse a steady, non-volatile approach to dividend management.

The 10-year average of the 3-year moving average of the earnings yield to Treasury yield ratio is 0.81.  The current ratio on the same basis is 1.24.  If the recent long-term past is an attractor, then we might expect the ratio to decline, which would require a rise in bond yields or a rise in stock prices or both.

We present the 10-year average of the ratio between the dividend yield and the Treasury yield for comparison and to tie into our prior article. 

The conclusions are the same as before.  Something important happened in the 1950’s to change the way bonds and stocks were valued relative to each other.  We don’t know if that was a permanent change or part of a very long wavelength cycle.

While you are pondering the mysteries of these long-term charts, think also about how we all came to accept trading stock certificates without demanding a bigger share of the cash profits pie.

Representative investments would be SPY (S&P 500), VTI (DJ Wilshire 5000) and IWB (Russell 1000) for stocks, and TLT  for long-term Treasury bonds.

Richard Shaw
QVM Group 

Disclosure: author owns VTI

This entry was posted on Wednesday, September 5th, 2007 at 1:03 am and is filed under Interest Rates, Market Conditions, Not Classified. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.