With dividend yields at generational lows and interest rates rising, past history indicates that investors shouldn’t expect anything close to a repeat of the 27% gain for the S&P 500 Index in 2021 in the short term.
When the yield on the 10-year U.S. Treasury note sank below 1% for most of 2020, it was well below the dividend yield on the S&P 500, meaning that even cautious investors could generate more income from stocks than bonds. According to data from CFRA research going back to the beginning of the current 10-year yield series in 1953, the S&P 500 rose 21% on average in the 12 months following a quarter when 10-year yields closed higher than dividend yields. But if 10-year yields are up to 2% larger than dividend yields–the 1.75% bond yield now is almost 0.5% larger than the S&P 500’s year-end 1.27% dividend yield–that subsequent return shrinks to 7.1%.
“Historically, the 10-year note has exceeded that of the S&P 500, mainly because stocks offer growth and yield, whereas bonds essentially offer just yield,” says Sam Stovall, CFRA’s chief investment strategist. “As the 10-year yield rises and becomes more attractive, then it’s going to possibly steal some interest from investors.”
The yield on 10-year Treasurys was larger than the S&P 500’s dividend yield for only 37 quarters in CFRA’s data–about 13% of the time–but the frequency has increased since the Great Recession. The bond yield was higher for 50 consecutive years until September 2008 after stocks began to crash, inflating their dividend yields for three quarters. Dividend yields were larger again in 2011 and 2012 after S&P downgraded the United States’ credit rating for the first time, then again in 2015-16 and 2020. Each instance was followed by strong performance, including a 23% return in 2009, 30% in 2013 and 27% last year.
Since those higher valuations cause dividend yields to fall, those periods rarely last long, and the two metrics flip-flopped last year, though bond yields have increased by 0.25% since the beginning of January to 1.75%, creating the largest margin between the two since 2019. Economists expect year-over-year inflation to hit 7% in Wednesday morning’s consumer price index report for December 2021. The Federal Reserve has also signaled it will raise interest rates three times this year, which could push 10-year yields over 2%.
Dividend yields have gone the other direction, slipping to a 20-year low of 1.27% at the end of 2021 after staying around 2% for the previous decade, according to S&P data measured every quarter. The last time it was this low was during the dotcom bubble at the turn of the century, before steep declines accelerated in 2001 and 2002. The S&P 500’s P/E ratio has again risen to more than 30, about double its long-term average, and Stovall says P/E multiples are also negatively correlated with 10-year Treasury yields. It all adds up to expectations for an underwhelming 2022, and stocks are down 1.1% so far in January.
“Don’t be surprised that as the 10 year note rises this year, as we anticipate it will, we will probably have to endure P/E multiple contraction,” Stovall says. “We’re still anticipating a gain, but we think it’s going to be more on the order of 5% versus 27% like we got last year.”