Last month, we looked at the relationship between dividend yield and the subsequent 5-year return for the U.S. stock market. The motivation: searching for a liaison that binds relatively high yields with relatively high returns. If it holds, then low yields lead to low/negative returns.
In our short sample of history, the relationship held up rather well. For the period January 1995 through February 2003, higher yields were linked with higher returns over the next five years. Indeed, running a regression analysis on the data produced a persuasive 0.95 R-squared. (A quick digression: R-squared ranges from 0 to 100. A reading of 100 means that the variance of one factor fully explains the movement of the other. A reading of 0 tells us that there’s no relationship between two variables. In short, the higher the R-squared, the greater the influence of one factor on the other.)
We also warned in that post that the strong relationship documented in 1995-2003 wasn’t absolute. We cautioned readers to “be careful about thinking the relationship offers easy and sure profits.” It doesn’t. Bottom line, we counseled last month to remain “skeptical” whenever someone shows you a relationship that purports to bring easy profits. No such animal exists, even if the evidence suggests otherwise in the short run.
Our essay inspired others to run a deeper analysis of dividend yield and stock returns. The Aleph Blog, for instance, correctly points out that over a longer sweep of history, the 0.95 R-squared we quoted falls dramatically. Using data from Professor Robert Shiller, Aleph reports that the R-squared for dividend yield and subsequent stock market returns is a mere 0.07 for 1871 to 2003. Crunching Shiller’s numbers on our own, we come up with a similar reading.
Does that mean that looking at the market’s dividend yield is worthless? No, not at all. Although a simple analysis of one holistic view of 100-plus years of stock market history seems to tell us otherwise, there’s a compelling reason to look at dividend yields as one of several metrics for judging prospective return for equities generally. No, we shouldn’t drive blindly down this road, or think we’ve stumbled upon a short-term trading strategy. But with eyes wide open, we should consider the possibilities of using dividend yield as one of several metrics for judging long-term return opportunities.