Stocks or bonds? Why not both?
By Laif Meidell, CMT, president of American Wealth Management, and portfolio manager of the AdvisorShares Meidell Tactical Advantage ETF (MATH)
At the start of trading on Thursday, the yield on the 10 Year Treasury note was the same as the dividend yield on the Standard & Poor’s 500 index, both paying 1.9 percent. Theoretically, stocks should pay a lower dividend than the U.S. Treasury note because they have the possibility to appreciate in value, whereas bonds do not. Of course, stocks are riskier, since there is no guarantee of the return of principal, but both are valued based on their expected future cash flow adjusted for risk.
The long-term relationship between the Treasury note yield and stock dividend yield has varied. From the late 1920s to the 1950s, stock dividends paid from 100 percent to 300 percent of T-notes. In the late ’50s, the trend began to reverse so that by the 1970s stock dividends were paying roughly 50 percent of the T-note yield. This relationship stayed in place throughout the bull market of the ’80s and ’90s up until the financial crisis, where the relationship began changing again. Today, the two are back at parity (100 percent of each other), just like the late 1920s.
Over the years, changes in tax rates and investors’ preferences for payout versus reinvestment has impacted stock dividend yields. However, the challenge today is determining what the bond and stock markets are telling us when their yields are roughly the same.
Those in the bullish camp might say that stocks are cheap, that there is more upside potential in stocks, particularly when you look at the 1970s when the stock dividend was 50 percent of T-notes. Using that perspective, the upside potential in stocks would be 50 percent. On the other hand, the bears can argue that the yields have been suppressed artificially by the Federal Reserve and now the ECB. If stocks are supposed to be half the T-note rate, then real rates should be closer to 4 percent.
Maybe the best perspective is a combination of the two. First, stocks aren’t cheap and longer-term bonds are expensive relative to stocks. Maybe in today’s market, the most misunderstood aspect from a historical perspective is risk, and when we finally wake up to that idea, our current paradigm will begin to change.
Both stocks and bonds are important parts of any portfolio and, tongue in cheek, they are the necessary evils that we as investors must work with. It appears that Mae West’s advice has been further-reaching than she realized when she said, “Between two evils, I always pick the one I’ve never tried before.” Like most things in life, the answer is somewhere in the middle.
This commentary originally published in the Reno Gazette-Journal. Performance numbers used in this article were obtained through eSignal and are not guaranteed to be accurate.