It’s been known for some time–decades, really–that relatively high dividend yields tend to precede relatively high returns in subsequent years. Graham and Dodd’s Security Analysis suggested as much about the relationship between valuation and return. More rigorous studies of the valuation phenomenon (of which dividends are only one measure) arrived in the 1980s, when a number of new research efforts found a strong relationship between relatively undervalued equities and higher prospective return.
One review of the possibilities came in a 1984 Journal of Portfolio Management article: “Dividend yields are equity risk premiums,” by Michael Rozeff. He explains that “the evidence dictates” that dividend yields can be used to time purchases. He warns against reading too much from specific dividend levels for establishing absolute buy and sell signals. He also counsels readers away from trying to profit from dividend-yield signals in the short term. Nonetheless, the basic premise, if not exactly original, reflects economic common sense, Rozeff argues:
My evidence indicates that returns increase continuously and monotonically as dividend yield in the prior year increases. My theory that the dividend yield is a measure of the ex ante risk premium explains why this is so. High returns tend to occur when the environment is perceived to be so risky that investors demand a high premium for holding stocks. Low returns tend to occur when the environment is perceived to hold such little risk that investors demand a low risk premium for holding stocks.
Subsequent studies lend support to the idea that valuation overall matters. For example, Robert Shiller, in Irrational Exuberance, argues in favor of return predictability based on valuation parameters. One example comes by way of a diagram in the book that plots price-earnings ratios against subsequent 10-year returns based on buying the S&P Composite Index (a proxy for U.S. stocks) at a given p/e ratio. The relationship, which draws on more than 100 years of market history through 1989, shows a “moderately strong” link between low p/e ratios and relatively high returns, and vice versa, according to Shiller.
Some simple tests seem to confirm the idea that long term investors should pay attention to valuation, as our chart below suggests. We’ve plotted dividend yields for the S&P 500 against the subsequent 5-year annualized total return for 1995 through 2003. The relationship is quite strong, at least in this sample period, posting a 0.95 R-squared. For example, the S&P’s dividend yield was a relatively high 2.12% in February 2003 and the subsequent five-year annualized total return was 11.6%. By contrast, in May 1998 the yield was 1.48% and the subsequent return over the next five years was negative 3.8%.
A longer review of dividend yields and subsequent performance reveals a similar trend, i.e., future returns tend to be higher when current yields are lower. It’s not absolute and it does always hold for each and every period. But generally, the evidence modestly suggests a recurring trend. This is hardly surprising. The notion that prospective returns are higher following a previous decline in price appeals to investor intuition, the empirical record and economic logic.
Nonetheless, we must be careful about thinking the relationship offers easy and sure profits. Let’s start by recognizing that the chart above tracks a sample period that, in absolute terms, may be abnormal. The overall relationship tends to hold over longer sweeps of history, but the actual numbers can vary quite a bit in the short term. In other words, a given dividend yield and subsequent return can be lower relative to the numbers above. Given that the 1995-2003 stretch was quite good for stocks, we should adjust expectations for less stellar periods.
Then again, the past year has been spectacularly bad for equities overall, which means that dividend yields are quite high by recent standards, as we discussed earlier this month. That implies that returns in the years ahead will be relatively higher.
Can we bank on that relationship? No, at least not to the extent that we bet the farm on the outcome. In fact, we should be skeptical. But we shouldn’t ignore the evidence. Indeed, if we’re partly optimistic that higher yields lead to higher returns, we’ll avail ourselves of the opportunity, but only to the extent we have confidence in the idea. In other words, we’ll adjust our strategic equity weighting down when yields turn thin, and raise the weighting when yields look appealing. If we’re 50% confident that higher yields lead to higher return, that suggests that half of our strategic equity weight will be adjusted based on current valuations.
As far as mere mortals can read such tea leaves and profit from the signals, prospective returns five years-plus in the future certainly look better now compared with a year ago. No guarantees, but the odds appear to be modestly tilted in the favor of long-term equity investors relative to a year ago. That doesn’t mean you can’t lose lots of money by buying equities today. Nor is it clear how long it will take to reap higher returns. We looked at 5 years in the chart above, but there’s nothing magic about that period.
There is no contract from the financial gods that insures you’ll turn a profit by buying stocks when yields have run upward. In fact, equity risk premia generally require faith. But to the extent that you have faith in the economy and its regenerative powers, the yield/return relationship looks modestly compelling, at least for those who are comfortable holding equity risk as a long-term proposition.