The long-term effects of the coronavirus pandemic on the global financial markets can only be confirmed in hindsight. However, we already know that aggressive monetary policy employed by central bankers all over the world to keep the economy afloat triggered a wave of inflation that has yet to be tamed.

In turn, higher interest rates raised bond yields to levels not seen in over a decade. Shortly after the outbreak of COVID-19 in 2020, the yield on the 10-year Treasury note plunged below 1%. Two years later it crested above 4% before leveling off.

Until recently, income investors were in a bind. If they bought fixed-rate bonds, they were locking in low yields on securities that were likely to decline in value once interest rates started rising. But if they bought high dividend stocks, they took the risk that the next major stock market correction could set them back even more.

Now that bonds are paying yields that generate meaningful income, that dilemma has been resolved. In its place is a new concern that may force growth investors to consider securities outside of their comfort zone. At the heart of the problem is a financial model used by the Fed to measure the relative value of stocks to bonds.

Earnings Yield

In simplest terms, the Fed model compares the earnings yield of the S&P 500 Index to the yield on the 10-Treasury note. The earnings yield is the trailing earnings per share for the index divided into its price. Mathematically, it is the inverse of a P/E ratio.

According to theory, when the earnings yield is higher than the bond yield, the stock market is bullish and at risk of becoming overbought. Conversely, the stock market is bearish and at risk of becoming oversold when the bond yield is greater than the earnings yield.

As the thinking goes, why risk taking a big loss in the stock market when less volatile bonds will pay you more interest than the rate at which companies can grow their profits? The difference between those two rates is the risk premium that investors are willing to pay for the capital appreciation potential of owning stocks.

For example, during the third quarter of 2022 the earnings yield rose above 5% while the T-note yield was around 4%. That works out to a yield premium of roughly 1%, which is not excessive in an inflationary environment. Over the next nine months, stock prices rose while bond prices remained stagnant.

By June of 2023, the S&P 500 earnings yield was only slightly higher than the yield on the 10-year Treasury note. At the same time, Fed Chair Jerome Powell stated that one or two more interest rate hikes might be necessary later in the year to push inflation lower.

Dividend Dogs

Here’s the problem for growth investors going forward. As bond yields increase, the earnings yield must go up to justify owning stocks over bonds. There are two ways that can happen; either companies must grow their earnings at a faster pace or stock prices must go down.

It is difficult for most companies to grow earnings during a recession. A shrinking economy means there is less money to go around. Each time the Fed raises interest rates, the relative value of stocks to bonds decreases while the odds of a recession go up.

Most investors don’t pay much attention to the earnings yield. It isn’t often quoted by the mainstream financial media, but you can track it on the NASDAQ website and compare to the 10-year Treasury note yield provided by the Fed.

Now that you know where to find that information, how can it help you? When the yield spread is narrow, as it is now, that usually means high dividend stocks are undervalued. Once bond yields start falling, those companies should perform particularly well.

During the first half of 2023, the ALPS Sector Dividend Dogs ETF (NYSE: SDOG) lost value while the rest of the stock market was going up. This fund holds the five highest-yielding stocks in ten sectors that comprise S&P 500 Index.

For the past six years, SDOG has alternated between hot and cold. After declining 11% in 2018, it gained 24% the following year. In 2020 it lost less than 1%, then jumped 24% in 2021. It was down slightly last year, suggesting the next 6 – 12 months could witness a strong rally.

Admittedly, that is mostly speculation and subject to a variety of factors that might not work out this time. If you prefer an investment strategy that produces consistent results, consider by premium service, Mayhem Trader.

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