Do Dividend Yields Indicate Stocks are Undervalued?

I reported previously on a post by the 5-Min. Forecast that discussed the possibility that stocks are undervalued based on the relationship between the 10-year Treasury bond yield, which has been bouncing around 2.5% today, and the dividend yield on the S&P 500, currently around 2.3%.

The stock dividend yield is about 92% of the bond yield.  The historical average is 42%.  To return to the historical average for today’s interest rate, the S&P 500 would have to rise to the neighborhood of 2,200, about a mile above the all time high of 1,565 on October 9, 2007.

To return to the historical average at today’s stock prices, the 10-year Treasury yield would have to rise to above 5%, a yield last seen nine years ago.

The following graph shows the relationships between interest rates, dividends and S&P 500 index value for a range of values with the stock dividend/bond yield ratio of 42%:

With the historic dividend to treasury yield ratio, the current S&P 500 index value correspond to dividneds of about $10.  Something is seriously out of whack.

What is going on here is that investors are pricing the S&P 500 as if there were not going to be further earnings and dividend growth.  Campbell, Giglio and Polk have done a detailed multivariant analysis that shows investors did not react to the latest bear market in stocks as they had to previous downturns.  This time investors did not reflect an expectation for stocks to recover.  Prices have not reflected historical relationships to bonds.  The discount to the “risk free” earnings rate has nearly vanished as the 10-year Treasury yield and the S&P 500 dividend yield approach the same value.

The following table shows what valuations are indicated for the S&P 500 for three ratios of dividends to treasury yields (the current 92%, the historic average of 42% and halfway in between) and for three values of 10-year Treasury yield.

The wide range of results reveals that there is no easy answer to the title question.  If interest rates rise and investor outlook is for little earnings and dividend growth, stocks may well be overvalued.  If interest rates remain low and investor expectations for dividend growth return only part way to the historic average, stocks are undervalued.  If interest rates remain low and investor expections return to historical norms, then stocks are dramatically undervalued.