For many investors over the past couple of years, the choice of where to put new money has seemed as easy as the AT&T (T) commercials in which schoolchildren are asked the comically obvious question: “What’s better - faster or slower?”
In the markets, the softball query has been, “What’s better, more cash income from a kind of paper called stocks, or less cash income from another sort of paper called government bonds?”
In 2011 the rate on the 10-year Treasury note sank below the dividend yield on the Standard & Poor’s 500 index – something that, since 1956, had only happened briefly near the bear-market lows of early 2009. Yet with the continued stock rally to new highs, and the sharp jump in Treasury yields in the recent bond-market rout, this is changing, and the mad dividend paper chase might be ending.
A new sort of leadership
This means, among other things, that the stock market will need new sort of leadership to emerge if it is to continue sidestepping significant setbacks and maintain its uptrend. And these new leaders will, by definition, be more economically sensitive and dependent on the dog whistle of corporate-profit indicators and the crackle of economic data headlines. Friday's brief decline on a weaker consumer-spending number, and subsequent bounce on a strong purchasing-managers survey, shows the tape is now more captive to the data flow.
While far from the only reason stocks began to look more attractive than “safe” Treasury debt to the professional-investor crowd in 2011, the yield advantage gained by large stocks became a core element of the bulls’ “elevator pitch.”
If one could be paid more cash from stocks in a low-rate world, they’d argue, and those dividends stand to grow over time with earnings and inflation, then shifting toward equities was almost a no-brainer.
In November the autumn downside choppiness gave way to the ensuing six-month levitation. Once dividend tax rates didn't rise sharply as feared and economic growth slid early this year, investors assertively took to the yield trade, flocking to utility shares and traditional blue-chip “Grandma stocks," while gorging on pure tailored yield plays eagerly served up by the investment industry, such as energy-themed “master limited partnerships” and real-estate investment trusts.
The Federal Reserve’s campaign to shrink the supply of risk-free assets was meant in part to push investors toward higher-risk instruments, but it also unleashed a mass yield grab.
As put by Jurrien Timmer, portfolio manager and director of global macro at Fidelity Investments: “This partly explains why – until a few weeks ago – the stock market rally has been led by these defensive sectors as opposed to the more traditional cyclical sectors, such as industrials, tech and financials. In a way, the stock market has become less of an economic barometer and more of an extension of the bond market, driven by the Fed's buying up of risk-free assets.”
Declarations of bond-market death spasms
Slowly improving U.S. economic conditions, receding fears of a financial-crisis sequel, preparation for the Fed to pare back its bond buying and the flooding of markets by the Bank of Japan with ultra-cheap yen have brought widespread declarations that the 30-year bull market in bonds is in its death spasms.
During May alone, the 10-year yield has shot from 1.64% to 2.17%. That’s almost precisely the current yield of the S&P 500, and at Tuesday’s midday all-time high in the index, Treasuries yielded more.
There’s nothing inherently crucial about this yield relationship – as noted, essentially for all of history before 1956, stocks yielded more than government debt, and from 1956 until 2008 dividend yields were lower than bond rates. Stocks have managed to fare well over long horizons under both regimes. Yet this new “yield parity” has removed one simplistic backstop premise for owning stocks today after a 150% gain in four-plus years. High-grade corporate bonds again yield a fair bit more than stocks, with less expected volatility.
Investors have not waited around to see whether their favorite yield plays will hold up or for bond yields to retreat quickly. The Utilities Select Sector SPDR fund (XLU) dropped 8.5% in the month through Wednesday. The JP Morgan Alerian MLP Index fund (AMJ), tracking the master-limited partnership sector, fell 6% in the past 10 days. And since May 15, the Consumer Staples Select Sector fund (XLP), a favorite of dividend hogs who didn’t mind buying pricey low-growth stocks, has trailed the broad S&P 500 by four percentage points.
For sure, dividends have always been and will continue to be a crucial driver of long-term equity returns. And companies have been raising the proportion of earnings they pay out as dividends from historically low levels, which should continue supporting their growth.
Yet if the pure dividend trade is petering out, it means the broad market needs yet another “immaculate rotation” from one category of stocks and industry groups to another – the way that the dividend stocks took the fore early this year as economic data began to soften.
There have been signs that big-cap Old Tech names such as Intel Corp. (INTC) and Microsoft Corp. (MSFT) could be up to the task. Banks such as Goldman Sachs Group Inc. (GS) and Citigroup Inc. (C) have taken flight in part due to the steeper yield curve from higher bond rates. Auto- and housing-related names are sturdy, and industrials have awakened as well, despite a sluggish global manufacturing climate.
So far this year, it hasn’t paid to bet against the flawless passing of the baton among market segments in motion. To date, some of the best investment advice has been to “dare to be lucky,” as the self-help folks might put it. Still, a market reliant on improving economic numbers – rather than simple “more cash or less cash” choices – needs to get the real macro evidence to hang tough after such an impressive run.