August 10, 2011 will go down in financial history. On that day, the S&P 500’s dividend yield at the close was 2.17%, which was above the yield on 10-year Treasuries of 2.14%. This was only the fourth such occurrence since 1958, with 1962 and 2008 providing the only other modern-day examples. More interesting to note is what it could potentially signal. Although the sample size is quite small, based on the three previous occurrences when the S&P dividend yield was above that of Treasures, the average return on the S&P 500 12 months later was 18.5%. Even 2008, in the midst of a financial market meltdown and with equity dividend yields being quickly reduced, produced a positive return of 23.5%.
The obvious question now is will history repeat itself?
To be clear, there could be more downside in the market because no one can time a bottom very well, especially when investors are panicking and irrational behavior prevails in the short term. But a decline in confidence is very different from a decline in financial worthiness.
Fundamentals do matter, and they are not as bad as the recent market activity would indicate. In fact, if the fundamentals worsen, it appears this scenario has been priced in. Even if we do enter a double-dip recession, most of the damage to the market probably has been done already because the average market decline from peak to trough is about 25%.
No one knows for sure if history will be repeated, but the fundamentals are much more favorable now than during the last S&P dividend yield occurrence in 2008.
Consider the evidence:
- Today, there is no liquidity crisis, as there was three years ago.
- Corporations are flush with cash.
- Corporate profits are at record levels, and more than 70% of earnings reports in Q2 2011 beat estimates.
- The broad economic data is still positive, admittedly slow, but positive nonetheless.
- We are adding about 150k jobs per month on average.
These are slow but positive numbers that against the backdrop of the recent equity markes moves seem to have a disconnect. Now, enter the Fed’s latest announcement meant to assure the market in the wake of the S&P U.S. debt downgrade. The Fed took the unprecedented step of signaling future action and putting a date on it. In the past, the Fed has said it will keep interest rates exceptionally low for an extended period of time. Last week, it said rates will be kept at these low, accommodative levels until at least mid-2013.
Reading the Fed’s tea leaves we arrive at two very interesting conclusions. First, the Fed has in essence thumbed its nose at S&P and its debt downgrade. Normally a reduction in creditworthiness drives up rates because investors have to be enticed to buy debt that, supposedly, is more risky. Bernanke and Company, however, have essentially told S&P: “You think rates are going up? Guess again. We’re keeping them low for two years.”
No silly downgrade is going to raise rates, not on Bernanke’s watch—unless, of course, economic fundamentals deem such a move appropriate. Further, the Fed is stating very clearly that investors will get nothing—nada, zero—in interest on short-term fixed income investments for two years, so look for something else.
As investors look for other opportunities, the obvious place will be stocks. The market appears to agree.