"Yield Spreads + Dividends + Nervous Markets = An OK Period for Stocks"

Sydney M. Williams

Thought of the Day

“Yield Spreads + Dividends + Nervous Markets = An OK Period for Stocks”

May 6, 2010

With the Yield Curve as steep as it is – the Ten-Year Treasury is 267 basis points above the Two-Year – it is hard to recall that a mere three years ago, concern was of an inverted yield curve. Despite the implications that an inverted yield curve suggested banks were having trouble making money in their loan portfolios – borrowing short and lending long is their business – their stocks were riding high. Citigroup, for example, was selling at 55.

Of course, as we now know, loans were only incidental to the business of many banks; as well, they hedge out differences between short rates and long rates. Nevertheless, an inverted yield curve has historically spelt trouble for banks, and the economy. Now, with a steeply sloped curve and assuming a financial reform bill does pass, lending is likely to become a bigger percentage of banks earnings, but now (admittedly with billions more shares outstanding) Citigroup is selling at less than one tenth of the price it sold at three years ago. This is not a recommendation of Citigroup, for I am far from qualified to do so; it is more of an indictment of the lack of common sense that too often courses through our markets. A yield curve as steep as this one acts as a free pass for banks. The question is how long will it persist and what will cause the slope to moderate.

Richard Shaw, the managing principal of QVM Group LLC, wrote a piece for Seeking Alpha in January 2007 pointing out that in 72 of the last 82 years the Yield Curve has been upward sloping. There were eight years in which the average weekly slope was inverted – 1927-1930, 1966, 1969, 1980-1981. Most of those years were associated with tough economic times. Mr. Shaw wrote, “It is generally held that a prolonged inverted yield curve produces a subsequent recession.” As we now know, 2007 became a ninth, and 2008 proved a doozy.

Yesterday Paul Hackett of Sidus Funds sent me a study he had done looking at spreads between Ten-Year Treasuries and One-Year Treasuries. There have been, according to his work, only three other times since 1976 when spreads exceeded 300 basis points – January 24, 1992 to January 29, 1993; July 25, 2003 to January 9, 2004 and May 29, 2009 through the present. As Mr. Hackett points out, “Up” markets persist even after super-steepness ends. Since the credit crisis, banks have been reluctant to lend to small businesses, despite the fact that large ones have meaningfully increased their liquidity. In the investment business, there are no infallible formulas, but when banks get paid to lend, without having to resort to the swaps market, it is difficult to imagine credit getting worse. Of course any financial reform bill will (or should) require reduced bank leverage, but leverage has already been reduced over the past year and a half, so further restrictions may prove not that onerous.

Credit markets, as we have mentioned on numerous occasions, rallied toward the end of 2008, with the TED spread (Three Month LIBOR less the Three-Month Treasury and a measure of liquidity) narrowing from over 450 basis points in September-October of that year to 131 basis points by year-end 2008. Today the spread is 21 basis points.

Bears (as do Bulls) always look to rationalize their opinions. Contagion has become the new watchword for bears. The Greek crisis, they tell us, will spread to Portugal, Spain and Italy and ultimately to the U.K. and America. Perhaps it will. I certainly worry about our deficits and the propensity we have to spend, not save. But when words like “contagion” become part of everyday speech, it suggests markets are at least prepared. Laszlo Birinyi had a piece yesterday portraying an historic perspective, providing charts on nine previous crises ranging from 1970 to the present, and covering such events as Penn Central to Orange County to Long Term Capital, and the conclusion is that they have all provided good ‘buy’ points.

Despite the rally we have had since the depths of March, 2009, and supporting the case for stocks, dividends have been rising. A year ago, when the yield on the S&P 500 exceeded that of the Ten-Year it was the first such instance in forty years. Since then bonds have fallen (yields have risen) and stocks have rallied (dividend yields have fallen). Even so, today the yield on dividend bearing stocks in the S&P 500, at 2.29%, almost exactly matches that of the Five-Year Treasury, at 2.31%. Over time, dividends tend to be increased. A Morgan Stanley study issued in April, suggested that 52.7% of total return to stocks over the past seventy years have come from dividends. Further, the study showed that the decade of the 2000s was the only one in the past seven to provide a negative total return, marking that period a “Black Swan” event. The 1930s was the last decade to show negative returns; according to the Morgan Stanley study, the 1940s were positive by 143.1%.

Nothing in the world of finance is writ in stone. However, despite the obvious problems we face, many of which we have discussed in previous pieces, it is difficult to imagine, with a steeply sloped yield curve, dividends being raised and
skeptics apparent in persistent low rates, that the next ten years will be as bad as the last.

………………………………………………………………………..

On Friday I will be out at yet another Grandparent’s Day, this time with two grandsons at Rye Country Day School. A blessing not an obligation, Grandparent’ Day is a wonderful way to spend quality time with special people.