Dividend yields don’t tell you everything, but they tell you a lot. Sometimes.
A fair number of studies over the years find that the correlation between yield and subsequent return over the next five years and beyond is strong enough to convince fair-minded investors to watch those yields for clues about what’s coming. In other words, higher yields have a tendency to lead to higher returns, while lower yields imply lower returns.
No, it’s not absolute. Nothing ever is in finance. That caveat aside, favoring markets, and points in time when yields are relatively higher has a tendency to improve the odds of capturing higher total returns in the years ahead. In fact, this is an old idea, captured in Ben Graham’s famous counsel that the market is a voting machine in the short run and a weighing machine in the long run. By that he meant that speculators rule now, tomorrow, next week and even next year when it comes to setting prices. But over longer periods, certainly five years or more, valuation dictates price. And dividend yield has proven to be an especially robust signal of expected returns.
With that in mind, we present two charts, each telling different stories. The first chart below graphs the dividend yield history for the world’s developed markets. Although the absolute levels vary, the trend of late has been consistent across regions: yields are up. That’s a function of the fact that prices have fallen relative to levels of a year ago.
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In contrast, emerging market equity yields generally have continued slipping, which is due to the fact that stock markets in the developing world have trended higher even as corrections roiled the developed world.
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Looking at market prospects solely on the basis of dividend yields suggests owning only developed world stocks and shunning emerging market equities. But if we consider growth opportunities, the emerging markets don’t look too shabby after all. In fact, they look quite a bit better than the outlook for the developed world. All of which implies that an exposure to emerging markets is warranted, even if yields are uninspiring.
Perhaps the key question is whether this is a good time to overweight emerging markets? Dividend yields suggest the answer is no, or at least that this is no time for overweighting these stocks. The case for caution is strengthened when you consider that emerging market stocks have been spared a correction, at least relative to the developed markets.
Then again, much depends on one’s time horizon. Traders will no doubt dismiss the counsel to stay wary on emerging markets. But for long-term investors, the case for caution may carry more influence.
To invoke Graham’s metaphor, it’s time to ask if you’re planning on voting or weighing.