Competition for Stocks

November 18, 2016

One of the key metrics experts have used to justify owning stocks is now working against them. For the past few years we've seen market analysts and advisors comparing stock dividend yields to Treasury Bond yields. While I've never agreed with this sort of comparison (more below), many people follow this simple strategy, so the move in interest rates since the election is important to market participants. Dividend yields are now below bond yields (blue & red lines in the chart below).

One thing that has always driven me nuts with this comparison is the fact it ignores the RISK of the investment. Stocks SHOULD have a higher yield because they have SIGNIFICANTLY MORE RISK. The chance of default on US Government debt is close to zero, while we've seen time and time again companies slashing their dividend payments during an economic slowdown. In addition, if the US Government were about to default on their debt you can bet our economy would be on the verge of collapse, meaning dividends would disappear (along with the value of the stocks paying them.)

 

Given the risk of stocks & their dividend stream, a more fair comparison would be high yield bond yields (the purple line above). These riskier bonds share similar economic & thus payment risk that the stock market would. To be fair, stocks do have upside potential, so looking at the earnings yield (inverse P/E ratio) we can compare the potential returns from stocks to the potential returns of high yield bonds (since all dividends must be paid from earnings.)

 

Regardless of the comparison, we have a lot of competition for stocks. 

 

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