Where I live, here in La Jolla, they almost cancelled the annual 4th of July fireworks. No matter. The stock market is offering plenty of its own pyrotechnics in the form of red lighting up stock screens across America. But is now the time to get all patriotic and buy U.S. bonds? During these potentially emotional times, let’s examine some cold hard facts in terms of likely future performance of quality dividend paying stocks versus the 10 year treasury bond.

The 10 year treasury currently yields around 2.89% per year (the 2-year recently hit an all-time interest rate low of about 0.58%).That means if you buy the 10-year today you are locking in sub 3% interest per year for 10 years. Compare this with a basket of 10 high quality dividend paying stocks, their approximate respective yields as today, and how quickly they grew their annual dividends on average over the last decade:

Company (Yield; 10-Year Annualized Dividend Increase)

KO (3.51%; 9.9%)

MCD (3.34%; 9.8%)

INTC (3.24% 23.9%)

PG (3.22% 11.0%)

JNJ (3.66% 14.1%)

ADP (3.38% 14.9%)

XOM (3.08% 6.5%)

EPD (6.42% 6.9%)

MSFT* (2.26% 29.0%)

*Started paying dividend in 2003

Let’s take a company like KO which has been paying dividends since 1893 (no, that’s not a typo) and increasing its dividend annually for decades. Assume KO increases its dividend at a 30% slower rate over the next 10 years, or a 7% annual increase. KO pays an annual dividend of $1.76 per share today. A little compounding math wizardry tells us that KO will be paying a dividend of $3.46 per share ten years hence. Divide that annual dividend rate into today’s stock price of about $49 and you get an effective yield (defined as future income divided by cost of stock) of about 7.06% – and this assumes you don’t reinvest any dividends. The reinvestment of dividends buys more shares which in turn pay more dividends and so on. Reinvesting dividends could easily boost your effective yield to well over 10%. So, while the purchaser of the 10 year treasury is locked into a sub 3% yield, in loading up on KO you start off well ahead of that and your income stream lead will only be extended each year that KO increases its dividend. Also, note that I have assumed KO increases its dividend by 30% LESS in the next 10 years than it increased it over the last 10 years, a period many are calling the ‘lost decade,’ and to be sure, a time when many US stocks went essentially nowhere from point A to point B. Any annualized dividend enhancements closer to the recent historical average only increases your future yield.

Now let’s look at capital appreciation potential in the coming years. As noted above, the time frame from 2000 to 2010 was one of the worst in history for US stocks (I am purposefully not addressing investing in foreign stocks, many of which did perfectly fine during the ’00s. The focus on this newsletter is that of income generation in an ultra low interest rate environment). But the common disclaimer “past performance is no guarantee of future results,” is a caveat that cuts both ways. When stocks have had such an extended poor run the likelihood of decent future performance is improved. Put another way, there has never been a 20 year period in US history with negative equity returns. So, while no one knows what will happen with US stocks tomorrow or next week or even next year, given today’s valuations (as opposed to the P/E ratio of the S&P 500 in 2000, for example) the probability that in a decade a nicely diversified basket of stocks like the ones noted above will have appreciated in price in addition to spinning off ever growing income streams in the form of dividends is increased.

Just to use one stock as an example, INTC trades for $19 and change today. Ten years ago it traded for about $75.8 at its peak. But back then it sported a P/E ratio of over 50X compared to a forward P/E of around 11X today. So, in virtually all cases with the 10 above mentioned stocks spanning a variety of industries, you are buying companies today that are trading at substantially more attractive valuations than they were 10 years ago, which by mathematical definition increases the probability of superior future returns.

How about the capital appreciation prospects for bonds? These are safe, right? The principal secure? Bond prices are inversely correlated to interest rates, meaning that prices go down (read: you lose principal) as rates go up. So when you hear statements like, “interest rates are at historical lows,” you should have the same reaction as if you were hearing commentators say, “stocks are trading at historically high P/E ratios” (a statement made repeatedly in 1999/2000 but one you won’t hear uttered today – for good reason). Think that bond prices can’t drop? Look at something ‘safe’ like the TLT (a bond ETF). TLT dropped nearly 26% in 2009 which was a year when stock prices increased. Why? Because bonds were in a bubble in early 2009 from the panic of late 2008 (when interest rates were being driven down during a flight to safety just like they are today), and as interest rates rose bond prices got crushed. Read that again. As interest rates went up, bond prices, even of ‘safe’ treasuries, dropped – like a rock.

Now will this happen to bonds tomorrow or next week or next year? Again, as with stocks, current challenging situations can last longer than expected. The case I am making is a simple but powerful one: If you have a reasonable holding time horizon, let’s say 5 years or more, and you are looking for any combination of income plus capital appreciation, equities offer a more compelling investment, regardless of what Jim Cramer is screaming today or tomorrow. Just look at the facts.

What if you buy that basket of high quality dividend paying stocks and the prices decline over the next few months or even next couple of years? Well, as long as your time horizon continues to be 5+ years, then you get the benefit of reinvesting the dividends at lower prices which means you will own more shares which means your effective yield 5 – 10 years hence will be even greater.

Indeed, it is hard to see daily headlines showing bad news on myriad fronts – political, economic, social, financial – but this always has been and always will be the case. As the saying goes, be greedy when others are fearful (as in now), or buy when there is blood in the street. It is emotionally the most difficult but financially the most rewarding. Always has been, always will be.