The Evolution of Stock Dividend Yields and Interest Rates

In general, the connection between dividend yields of stocks and interest rates appears to be inconsistent. The relationship between the 10-year treasury interest rate and the dividend yield of the SP 500 from 1871 to 2019 is, on average, negative. However, there are both positive and negative components contributing to this overall trend.

Theoretical Foundations: Real Interest Rates and Stock Returns

The interest rate can be broken down into a real interest rate and expected inflation. When real interest rates on bonds rise, it can be expected that the real expected return on stocks will also increase, as investors have a choice between buying stocks or bonds. Although this correlation is not exceedingly strong, a positive relationship exists due to the accessibility of alternative investment vehicles.

Stock Returns and Expected Inflation

There is no intrinsic reason for stock returns to be influenced by expected inflation. In a scenario where all prices rise proportionally, the revenue, expenses, and profits of companies will maintain their relative balance. While this is not entirely accurate, stocks typically offer inflation-protected returns, suggesting that their expected returns are minimally correlated with expected inflation.

Company Decision-making and Dividend Yields

Companies have the flexibility to distribute their profits as dividends or reinvest the cash for future growth or buybacks. Thus, even if there were a positive correlation between stock returns and interest rates, it might not manifest in higher dividend yields. The decision of how to distribute capital is driven by various factors, including the company's strategic goals.

Historical Data and Trends

The following chart offers a historical perspective on the relationship between interest rates and dividend yields. Observations from the data provide insights into different market regimes:

Before 1950, dividend yields displayed more volatility, while interest rates were relatively stable. Dividend yields were higher than they have been since and interest rates were lower, with dividend yields also being higher than interest rates. From 1950 to 1970, dividend yields declined while interest rates increased significantly. In the 1970s, dividend yields rose as interest rates soared. From 1980 to 2000, both dividend yields and interest rates fell. Since then, dividend yields have slowly increased while interest rates have continued to decline.

From this historical analysis, it is evident that there is no clear and general tendency for dividend yields to be high when interest rates are high. The trends have shifted over time, indicating that other factors, such as economic conditions, investor sentiment, and company strategies, play significant roles in determining dividend yields.

Conclusion

While there may not be a consistent relationship between dividend yields and interest rates, historical data and theoretical models provide a framework for understanding the interplay between these two key financial indicators. Investors and analysts should consider a range of factors beyond just interest rate trends when evaluating stock dividend yields.