Where The Income Is

5/11/2009


One problem shared by most investors — regardless of their return requirements and investment approach — is that that they want it all.

Income-oriented investors want dividends, but they also want enough growth to keep the payout rising. And some capital gains would be nice.

Aggressive investors want capital gains, but they also don’t want to take too much risk. And some dividends would be nice.

The Dow Theory Forecasts generally focuses on stock investments, but in this month’s Income Spotlight we look at the income, total return, and risk of various types of investments.

Income accounted for most of the returns of government bonds from 1926 through 2008. While large-company stocks once paid dividends nearly comparable to those of bonds, yields have trended lower over the last 20 years.

Bond returns lag
In the 83 years since 1926, long-term government bonds generated an annualized income return of 5.2%, versus a total return of 5.7%. In contrast, large-company stocks managed a total return of 9.6%, with an income return of 4.1%. Over the last 10 years, stocks’ income return fell to 1.7%. Income return represents the return from dividends alone, while total return also reflects capital gains and dividend reinvestment.

During the 10-year bull market that ended in 2000, stock prices rose so much faster than dividends that yields reached record lows, with the S&P 500 Index’s yield dropping to 1.1% in 2000. The S&P 500 currently yields 2.5%, well above the 1.8% to 2.0% it has yielded for most of the last six years.

Today’s higher yields may overstate the income appeal of stocks, as dividend payouts are on the decline. The S&P 500 Index’s dividends fell 7% year-over-year in the December quarter and 16% in the March quarter, the largest declines in at least 20 years.

Yields tell the tale
Based on current yields, both stocks and the lower tier of investment-grade bonds look attractive relative to Treasuries and Aaa-rated bonds. In today’s market, it could pay to take on some extra risk.

Yields on both high-quality corporate bonds and government bonds are well below historical norms, as shown in the nearby chart, in large part because a flight to the perceived safety of such bonds during the stock-market downturn drove bond prices up.

At the moment, the spread between the yield of corporate bonds rated Aaa (highest rating available) and Baa (lowest investment-grade rating) is 2.7%, well above the average of 1.1% since 1976. The spread between Aaa-rated bonds and 20-year Treasury bonds is 1.4%, versus a historical average of 0.9%.

These unusually wide spreads suggest that even within the bond arena, investors are demanding more compensation than is typical for taking on additional risk. Aaa-rated bonds are riskier than Treasurys, and bonds rated Baa are riskier than Aaa bonds.

Stock-index yields look unusually high relative to bond yields. Since 1976, the S&P 500’s yield averaged 4.3% below that of long-term Treasurys and 5.2% below that of Aaa-rated bonds. Today, stocks yield just 1.6% less than Treasurys and 3.0% less than bonds rated Aaa.

While yields and yield spreads provide useful information, yield is not the best indicator of value for individual stocks. To separate the best dividend-payers from the herd, look for other qualities as well, including Quadrix® Overall and Value scores and dividend-growth prospects.

Yield to wisdom
In today’s market, yields tell a compelling story. Pay attention to them, but don’t overreact. Investors should not let yields dictate asset-allocation decisions. Over long periods of time, bonds tend to deliver higher income but lower total returns than stocks. That is not likely to change over the next decade. In fact, the absolute returns of stocks are so much higher than those of bonds that even income-oriented investors should take note.

PORTFOLIO RETURNS

The portfolios below represent long-term allocations. Data reflect annual returns from 1926 through 2008 and exclude transaction costs. Historical results don’t necessarily translate into future returns, but they they provide some perspective on how different types of portfolios could perform.

Higher-return portfolios tend to be more volatile as measured by standard deviation. But there are other types of risk. The most aggressive portfolio never generated a return lower than 234% for a 20-year period, more than double the worst return for the most conservative portfolio.

Aggressive Portfolios —————————— Conservative Portfolios
1
2
3
4
5
6
7
8
% of large-company stocks
30
40
50
50
40
35
25
25
% of small-company stocks
55
40
25
15
15
10
10
0
% of long-term
corp. bonds
10
15
10
15
10
10
0
15
% of long-term
gov’t bonds
0
0
5
5
10
15
20
15
% of inter.-term
gov’t bonds
0
0
0
5
10
10
20
20
% of cash
5
5
10
10
15
20
25
25
Annualized
return (%)
10.9
10.4
9.8
9.2
8.7
8
7.5
6.6

Standard
deviation (%)

23.4
20.5
17.7
14.8
12.8
10.5
8.6
6.7
Sharpe ratio
0.33
0.36
0.38
0.41
0.44
0.47
0.51
0.52
% of down years
28
25
23
23
23
19
19
14
2008 return (%)
(30)
(28)
(25)
(21)
(15)
(10)
(5)
(1)
Worst 1-yr.
return (%)
(42)
(37)
(34)
(30)
(26)
(21)
(17)
(12)
Worst 5-yr.
return (%)
(61)
(53)
(44)
(33)
(27)
(18)
(12)
2
Worst 20-yr.
return (%)
234
218
178
163
162
144
133
101
Source: Morningstar.

From 1926 through 2008, a $1,000 investment in a portfolio consisting of 70% large-company stocks and 30% long-term government bonds would be worth nearly $1.2 million, more than three times the value of a similar investment in a portfolio with 70% bonds and 30% stocks.

Of course, this data inspires another question: If stocks perform so much better, why bother with bonds at all? If the events of the last year-and-a-half haven’t sunk in, consider the risk data in the chart above.

Adding bonds to a stock portfolio does more than reduce long-term returns — it reduces volatility. A portfolio of 70% large-company stocks and 30% long-term government bonds would have generated an annualized return of 8.9% from 1926 through 2008, somewhat lower than the 9.6% return of a stock-only portfolio. However, the addition of the bonds reduced portfolio volatility by more than 28%.

What it means to you
Our discussion of yields and investment returns leads to at least two useful conclusions:

The disparity in wealth built by stocks relative to that built by bonds can cover a lot of retirement expenses. Most investors, regardless of their age, should have at least some of their money invested in stocks. At the same time, stocks are simply more volatile than bonds. As such, most investors, regardless of their age, should have at least some of their money invested in bonds. How much to allocate to each asset class depends on a range of factors other than age, including wealth, risk tolerance, income needs, and long-term return requirements. Check out the table above to see the risk and return of various allocations.

For most investors who seek to live off the income from their investments, the Forecasts recommends a diversified portfolio that includes stocks, bond mutual funds, and perhaps other types of investments for diversification purposes. Better to earn a 3% yield on a diversified portfolio with growth potential and sell stocks periodically than to go with all bonds simply to boost the yield.


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