Dividend Yield v. Subsequent 12 month S&P 500 change (excluding dividends), 1945-May, 2007

Dividend Yield v. Subsequent 12 month S&P 500 change (excluding dividends), 1945-May, 2007

Believe it or not, the much-maligned dividend yield, scoffed at by late 1990s advocate of a New Paradigm and the end of the business cycle as we knew it, remains an extremely powerful driver and predictor of total return. Despite a shift away from dividends to buy backs and reinvestment, the boring, old, unfashionable quarterly payout relative to price remains one of the most robust ways of determining stock market valuation.

Dividend yield versus next 12 month change in the S&P 500 , January, 1945-May, 2007, n = 737:
		Earnings yield		Next 10 year return (annualized):
Percentiles:	n	From:	To:
Min-25%	184	1.06%	2.95%	7.58%
25-50%	185	2.95%	3.51%	2.89%
50-75%	184	3.51%	4.64%	11.49%
75-Max	184	4.64%	8.62%	13.22%
		Correlation:		23.3%
All:	737		Average:	8.79%

With the exception of the lowest quartile of dividend yields, every quartile showed a stepwise decrease in next 12 month return as the dividend yield was decreased. Only when the dividend yield was above average (3.51%) did the market return more than 10%. This is not quite as dramatic as the earnings yield, perhaps because the dividends yield is a measure of both underlying earnings strength as well as the payout ratio, or the proportion of those earnings paid out as dividends. Poor earnings, or a high stock price relative to low earnings, are almost always a sign of trouble, but clearly many excellently run companies with healthy earnings growth pay low or no dividends.

Despite this observation, the dividend yield really shines when the time frame is extended to 10 years. Again, using the dividend yield at the end of each month and comparing it to the next 10 years total return (including dividends, annualized) of the S&P 500, a very high correlation emerges:

Dividend yield versus next 10 year average annual S&P 500 total return (including dividends), January, 1945-May, 2007, n = 630:
		Earnings yield		Next 10 year return (annualized):
Percentiles:	n	From:	To:
Min-25%	158	1.73%	3.13%	7.88%
25-50%	157	3.13%	3.74%	10.53%
50-75%	157	3.74%	4.88%	14.09%
75-Max	158	4.88%	8.62%	16.65%
		Correlation:		67.7%
All:	630		Average:	12.29%

The .677 correlation (the highest of any variable explored in this article) means that most of the subsequent stock market gains can be predicted by the dividend yield at the start of the rolling 10 year period. Each quartile shows a rising 10 year average annual total return with rising dividend yield. Investing in the highest quartile by dividend yield (dividend yields of 4.88% or higher) led to subsequent returns of 16.7% over the next 10 years.