Market Factors: Why 4.5 per cent is a big number for investors. Plus, the downside of dividends

In this Market Factors, we describe why equity investors need to follow the U.S. ten-year bond yield, explain why dividend yield is less important than many believe, and take a look at some of the most remarkable important scientific developments of 2024.

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Bond yields

Above 4.5 per cent is bad

Morgan Stanley chief investment officer Michael Wilson sees the recent increase in longer-term U.S. bond yields as a potential sign of concern regarding future funding of the country’s massive deficit. A higher margin of safety in the form of higher yields is being demanded by global investors.

As the year began, Mr. Wilson saw a U.S. ten-year yield of between 4.00 and 4.50 per cent as the sweet spot for equity valuations.

It is no surprise to him then that stock market leadership narrowed to higher quality stocks (those with healthier balance sheets and more reliable earnings growth) and price volatility intensified as the yield climbed to over 4.6 per cent this month.

The strategist predicts that the strongly negative correlation between bond yields and equity prices will continue until the ten-year yield falls back below 4.5 per cent. In this high-yield environment, he favours financial, media and entertainment stocks and likes consumer services stocks over consumer goods.

It is also important to note the implications of deficit concerns driving yields higher. It is a more intractable problem than inflation and one that will worsen if political instability intensifies.

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Income

Why dividend investors can underperform

Ritholtz Wealth Management CEO Josh Brown wrote a column that will be considered heresy by most of our readers. It’s called Dividends are a feature, nothing more. He compares buying a stock for its dividend with buying houses based on their garage.

Mr. Brown notes, correctly, that dividend investing in any form is almost certain to outperform the S&P 500 over longer periods of time.

The column recognizes the benefits of dividends but it spends more time on their limitations. For Mr. Brown, the yield is no more important than the management team, revenue growth, market share or the competitive moat. Dividend cuts can be disastrous for overall portfolio returns.

His piece glosses over the benefits of stable yields for retired investors who are willing to sacrifice capital gains for stability and maintaining a standard of living.

I think the piece is valuable as a reminder that dividend investors have benefitted from generally falling bond yields over the past 42 years – lower fixed income yields make equity dividends more attractive by comparison. The Canadian ten-year bond, however, hit 54 basis points during the pandemic and had no where to go but up. The multi-decade trend of falling yields is over.

Diversions

Nine remarkable achievement in science in 2024

I like to remind myself that amazing human achievements are happening all the time, as exemplified by Nine of the Most Remarkable Scientific Discoveries of 2024 in Discover Magazine. The achievements cover a wide variety of disciplines, from drug development – a new treatment for HIV/AIDS with a near-100 per cent success rate and a blood test to detect cognitive decline – to the complete neurological mapping of a housefly brain.

Consistent readers of the Market Factors newsletter will know that I am not a big fan of discovery number five “CRISPR and AI Team Up” because it combines the two most terrifying new technologies of the 21st century. Anything could happen there.

The essentials

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Globe Investor highlights

John Heinzl explains why he’s not hanging up on Telus even as telecom stocks get crushed. Meanwhile, David Berman argues Aritzia has a lot to live up to given its lofty expectations.

Rob Carrick looks at some options for investors who want 12 months of peace while the Trump presidency sorts itself out

David Rosenberg says TSX investors don’t have much to worry about even if Donald Trump proceeds with 25 per cent tariffs on Canadian imports

Tim Shufelt on why most thematic ETFs fail to deliver

Economists overall are quite confident another rate cut looms this month by the Bank of Canada, suggests the latest Reuters poll

Some suggestions from veteran fund manager Tom Czitron on how to make money from bonds in 2025

Ken Fisher explains why stocks only value factors affecting future profitability about three to 30 months ahead

What’s up next

The domestic CPI reading for December will be released Tuesday and a 1.8 per cent year-over-year increase is expected. Retail sales, which I have been watching carefully for signs of household financial stress, will be reported Thursday. The month-over-month reading for November is expected to come in 0.1 per cent higher.

The economic calendar in the U.S. is lighter than normal this week. Existing home sales for December is the only release of wider interest – 4.2 million in sales is forecast.

There are a few notable quarterly earnings reports this week. Netflix Inc. (US$4.179 per share expected) reports Tuesday. Procter & Gamble ($1.865) and Johnson and Johnson ($2.004) both provide results on Wednesday. General Electric Corp ($1.038) and American Express Co. release results Thursday and Friday respectively.

See our full economic and earnings calendar here (You can bookmark the page – it gets updated weekly)