“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so. “ – Mark Twain

The year is 1958. 

You are an intelligent and prudent investment manager, schooled in the basics of finance with a strong understanding of investment history. 

Of the small number of things that you know for sure, one is that the dividend yield on stocks should exceed the interest rate that you earn on a bond. 

It has always been so. 

It makes perfect sense, of course. Equities are riskier than bonds, and so the higher dividend rate should compensate you for that risk.

And so it was that in September of 1958, when the economy was experiencing a recession and yet the stock market was up over 150% from levels just a decade earlier, that the dividend yield on stocks fell below the interest rate offered by 10-year Treasury bonds.

You might have believed that it was a temporary aberration, fuelled by speculation. There was a lot to worry about, including escalating Cold War tensions. What were investors buying stocks thinking? Didn’t they know any better?

The long-term chart of interest rates versus dividend yields looked something like this:  

It would have been easy to conclude that the time was right to sell stocks until sanity returned.

In Against the Gods, Peter L. Bernstein writes:

In an article in Fortune magazine for March 1959 Gilbert Burke declared, "It has been practically an article of faith in the U.S. that good stocks must yield more income than good bonds, and that when they do not, their prices will promptly fall." There is reason to believe that stocks yielded more than bonds even before 1871, which is the starting point for reliable stock market data.

With the benefit of hindsight, we know that things did not turn out the way they were supposed to. At that turning point (seen about 1/3 of the way through the chart below), who could possibly have predicted that bond rates would continue to exceed dividend yields for over 60 years!

Anyone using this as a signal for the overvaluation of stocks would have missed out on the single greatest period of wealth creation in history. How many money managers were caught offside by this? And how long did they cling to the stubborn belief that interest rates should be lower than dividend yields?

Bernstein expanded on this in a 2004 interview with Jason Zweig:

[For the first time in history,] stocks began to yield less than bonds, and it was not something tentative. The lines crossed without any period of hesitation and just kept on going. It was just, zzzoop! All my older associates told me that it was an anomaly and it could not last. To understand why that happened and what that meant — and to recognize that what was accepted wisdom for a couple hundred years could turn out to be wrong — was very important. It really showed me that you don’t know. That anything can happen. There really is such a thing as a “paradigm shift,” when people’s view of the future can change very dramatically and very suddenly. That means that there’s never a time when you can be sure that today’s market is going to be a replay of a familiar past.

Markets are shaped by what I call “memory banks.” Experience shapes memory; memory shapes our view of the future. In 1958, younger people were coming in who had a different memory bank, who did not carry all that extra baggage of depression and world war and tariffs. The bond market went down and the stock market didn’t go down, because people with a different memory bank didn’t know that wasn’t “supposed” to occur.

In retrospect, interest rates being higher than dividend yields makes perfect sense, of course. Because dividends grow, and equities also benefit their owners by offering the potential for capital gains. 

Right? 

Now there is so much to unpack here that one could write a book on the subject. Yes, there’s the evergreen conclusion that nobody knows anything, but there’s also so much more than that.

What assumptions are you carrying that are not serving you as an investor?

What are the things we know for sure that might not be true? 

Maybe it relates to the appropriate level of interest rates, or earnings multiples. 

Maybe it has to do with corporate profitability, or the law of large numbers. 

It might possibly involve the limits of government debt, or the impact of fiscal profligacy.

Remember, nobody knows anything. 

The things you can wrap your mind around and control - for example, investing in the shares of high quality, profitable companies and holding for the long term - are the things you should focus on, lest you sell all your stocks in 1958, and die waiting for the perfect moment to get back in.