In the third quarter, an unusual situation arose in U.S. financial markets: dividend yield on stocks surpassed the interest rate on the 10-year Treasury bond. While some technical analysts saw this as a strong “buy” signal, and the market did subsequently rally, the real explanation is probably far less favorable for stocks over the long run.
Since early July, financial markets have been characterized by extreme volatility and risk aversion. Fears of a euro-zone break-up and an ensuing banking crisis, as well as forecasts of a possible recession in the United States, triggered a flight to Treasuries. Investors ignored a downgrade of the U.S. sovereign debt rating by Standard & Poor’s and pushed the rate on the long bond to record lows. At one point, the 10-year bond yielded less than 1.75 percent. Meanwhile, a sell-off in stocks boosted dividend yield on the S&P 500 to 2.2 percent. That on the 30 stocks in the Dow Jones Industrial Average was even higher.
Not that these are attractive yields. They remain solidly negative in inflation-adjusted terms. Moreover, even the yields offered by Altria (over 6 percent) and Eli Lilly (over 5 percent) were small consolation for battered investors.
Dividends are fundamental to stock investment. Conceptually, they determine the price of a share, which is defined by economists as the discounted present value of all future dividend flows from owning that stock. This accounts for the difference between the company’s book value and its market capitalization. Since future dividend flows can’t be known for certain, stock prices fluctuate as market participants guess at their values.
But ever since Wall Street began to rally in the early 1980s, initiating a major bull market, actual dividends played only a minor part of the stock-ownership revolution of the past few decades. Some of the most attractive and widely held stocks of the era never paid dividends at all, and some household names still don’t, including Google and Apple.
The traditional explanation for this is that new companies, active in new markets, need to invest and grow their business. Their cash resources should be deployed to gain a competitive advantage, build a brand and increase market share. Accordingly, few of the innovative companies that trade on Nasdaq pay dividends.
On the other hand, companies in mature sectors are supposed to generate steady, predictable profits and reward their shareholders with stable dividends. Shares of blue chips that have consistently paid cash to their shareholders over many years can be valued in relation to bonds, based on their respective yields. Economist Gary Shilling calls such shares “stocks that look like bonds.”
However, the traditional approach to dividend policy has gone out the window in recent decades. Many start-ups have been able to build global brands relatively quickly and acquired extraordinary pricing power even in rapidly changing markets. They are consistently and highly profitable, debt-free and generate a lot of cash. As a result, they are sitting on large holdings of cash. Google, for example, has over $40 billion even after buying Motorola Mobility for $12 billion in August.
Then again, “mature” industries have gone through dramatic technological and competitive changes. The auto industry is a case in point: Ford and GM, which still have solid global market shares and pricing power, had to suspend dividends and GM even sought bankruptcy protection in 2008.
Automotive parts suppliers have had to reinvent themselves as high-tech operations and to invest heavily to maintain sales. Johnson Controls, which makes interiors and batteries for original equipment manufacturers, has become a global leader in the lithium-ion battery technology for electric cars. It is competing with a variety of green-tech start-ups. Yet, it has been paying regular quarterly dividends since 1887 — for nearly a century and a quarter!
Apple, on the other hand, suspended dividends when it ran into trouble in the mid-1990s. Since then it has bounced back and in mid-2011 it even surpassed Exxon Mobil as the world’s largest industrial corporation in terms of market capitalization. Yet, no dividend is in the offing.
Dividends = Risk
A period of intense stock price volatility in mid-2011 suggested one possible explanation for higher dividend yields relative to bonds: volatility is a market measure of risk, and stocks have become riskier to hold than bonds. Hence, investors are demanding higher returns from their stock holdings. As a result, companies are faced with a dilemma: if they want to support the value of their shares they will need to increase dividend payouts (or start paying dividends if they currently don’t.) Those who don’t increase their dividends risk seeing intensified volatility of their share prices.
This is already happening. Stock analysts have noted an increase in dividend payouts by companies in the S&P 500 index, which collectively are sitting on several trillion dollars of cash holdings. Other companies have been announcing stock repurchase programs. Several articles in recent months have predicted that a flood of dividends and other cash to stockholders will be unleashed in 2012 and beyond.
The connection between dividends and risk needs to be explored in greater detail. Companies in mature industries can be viewed as riskier than the ones that are active in new markets, which is why they have to offer dividends. After a period of stagnation they are likely to become subject to technological change and to increased competition from newcomers with better ideas. The automotive industry once again provides a textbook example of how it can happen. Meanwhile, high-tech companies, especially highly profitable ones, offer investors such strong guarantees of continued profitability that they do not need to return any cash to investors at this time.
To think that stocks have gotten riskier in comparison to U.S. Treasuries flies in the face of logic. The U.S. government is heavily in debt and S&P did cut its AAA credit rating, even though investors seem to ignore this fact. The government in Washington is dysfunctional and the idea of default was raised over the summer. The threat of a government shutdown arises every few months. Finally, bonds are at a tail end of a 30-year rally, with bond yields at record lows and bond prices at record highs. Their upside pales in comparison to their downside.
The gap between low bond yields and higher stock dividends can mean only one thing: that investors have no expectations of an economic recovery that would reduce the safe-haven premium on U.S. Treasuries or raise the specter of higher inflation.
In this environment, who could blame companies for not hiring or investing? Just like investors in financial markets, they expect little demand growth in the future that would justify any substantial investment. So even though the corporate sector has seen remarkable profits growth in recent periods, businesses have been simply accumulating cash on their balance sheets.
There is an interesting paradox concerning profits: stock prices do not reflect past or present profits, only future ones. Nor is excess cash on the balance sheet especially useful in driving up a share price. Investors want the company to invest in order to assure future dividend flows. In the absence of profit-generating investment opportunities, share prices are certain to stagnate, reflecting expectations of stagnating profits. Share prices may be supported by higher dividends for a while, but if higher dividends do not reflect a plausible steady increase in future profitability, their effect will be only temporarily.
The dearth of investment opportunities is the result of sluggish demand. Middle class incomes have been stagnating for some time, and now the U.S. economy appears to have been additionally saddled by confidence-sapping long-term unemployment. As each company individually controls its costs to maximize profits, collectively they hollow out their own markets, because the universe of employees is also their customer base. None of that is good news for equities.
Alexei Bayer is an economist and author based in New York City.