By: Larry MacDonald

During the last bull market, dividends yielded an average 1.5% while high-grade corporate bonds yielded 6%. When yields get to these levels, as William Bernstein suggested in The Four Pillars of Investing, long-run returns on the two assets are likely be the same (6%).

More generally, as Bernstein believes, it may be better to estimate expected returns for stocks according to the dividend discount model rather than extrapolate them from the past. After all, one of the cardinal rules of finance is that the value of an asset lies in its stream of discounted income. Specifically, investors are advised to use the Gordon model whereby:

Market Return = Dividend Yield + Dividend Growth

Taking the market’s historical annual average dividend yield of 4.5% and historical average dividend growth rate of 5%, one gets a total annual return close to 9% for the long run. But if dividends at a particular point in time yield 1.5%, the expected long-run return will be 6% (assuming 5% growth rate in dividends). A lower weight for equities may then be justified.

With dividend yields in North America presently averaging close to 3%, now would seem to be a better time to have increased exposure to equities. The settings for the Lazy Portfolios may now be more appropriate. Dividend yields in Europe are above 4.5%, suggesting it might be better to tilt more toward foreign markets where yields are so high. Caveats would be i) currency risk and ii) assumed dividend growth rates (which may turn out to be different than 5% per year). Also, other factors, such as small caps and undervalued stocks, have in the past been worth emphasizing.