Bond Yield Signal Could Bode Ill for Stocks

What it means when short-term bond yields outpace the SPX dividend yield

May 22, 2018 at 7:45 AM
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Bond yields barreled back into focus last week, as the 10-year Treasury yield pushed to seven-year highs above 3%. The 2-year yield set an even longer-term milestone, as it accelerated on Tuesday to its highest level since 2008. But perhaps most noteworthy is a detail pointed out by Schaeffer's Quantitative Analyst Chris Prybal -- the fact that the 2-year yield simultaneously surged above the S&P 500 Index (SPX) dividend yield for the first time in a decade.

As of the close on Tuesday, May 17, the SPX dividend yield was 2.35%, compared to a 2-year note yield of 2.58% (and a 10-year yield of 3.09%). The accompanying chart offers a long-term view of the SPX dividend yield less the 2-year yield, with that recent move below zero denoting the recent flip-flop in rates.

There are a couple of points worth making about this chart. First, we're still far from an extreme, in terms of how wide the gulf can get between the SPX dividend yield and the 2-year Treasury yield (note, most recently, the 2007 extremes around negative 3.00%). And second, prior instances where the SPX dividend yield has topped the 2-year bond yield have typically been solid buying opportunities for stocks (note the action in 2003 and 2009 as evidence). So now that we find ourselves in the opposite situation, what can we expect from stocks?

Points of comparison are few and far between, due to the infrequency with which short-term bond yields have surpassed the SPX dividend yield. Going back to 1990, we find just three instances -- in 2004, in 2008, and just a few days ago -- where the 2-year note yield has settled north of the SPX dividend yield. And while the small sample size demands a healthy dose of proper perspective be applied to this data, Prybal found that SPX returns following the last two occurrences were fairly bleak.

Specifically, average SPX returns following one of these "yield crossover events" range from typical to slightly above-average in the immediate aftermath. But after the one-month mark, average SPX returns take a turn for the worse.

Looking at the average two-month, three-month, four-month, and six-month returns after a signal, the SPX is negative over every time frame -- in the neighborhood of 3% to 4% losses from two months to four months out, with the average six-month return widening to a drop of 15%. By contrast, average "anytime" SPX returns over these time frames are all positive going back to 1990, ranging from 1.4% over two months to 4.4% over six months.

The fact that the 2008 signal preceded the "black swan" implosion in financial markets later that year is a noteworthy caveat that adds valuable context to the negative returns that ensued. For what it's worth, the SPX underperformance following the 2004 crossover was not nearly as dramatic.

On the one hand, this is an expected limitation of such a small sample size, and reason to consider these past returns with a healthy dose of skepticism and a critical eye. And on the other hand, it would be ruthlessly optimistic to overlook the fact that the last such signal preceded a major disruption in the global financial system, along with a historic bear market for U.S. equities. As such, this deviation from the norm in the relationship between the SPX dividend yield and 2-year note yields is one we'll be monitoring closely.

spx dividend yield vs 2-year treasury yield

Subscribers to Bernie Schaeffer's Chart of the Week received this commentary on Sunday, May 20.

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