Wednesday, June 24, 2009

Yield matters

When it comes to stocks, yield hints immediate future price moves via implied professional sentiment. Keep in mind that large, price affecting orders come from institutions and high value traders who make decisions largely by economic means, not historical price charts.

Yield vs. fixed interest

The relationship is simple. When dividend yield of a stock exceeds fixed interest instruments (bonds, savings accounts, and etc.), some large investors find the said stock more desirable due to a relatively higher return over time. So naturally when yield makes a historically significant high, large buying orders come and push the price up in the immediate future, and vice versa.

Of course if we take into account of credit risk (listed company going bankrupt) or direct market directional risk, it becomes a bit more complicated. Despite that, from personal experience and empirical evidence, not all institutional investors comprehend these issues. Remember how I mentioned that 80% of hedge fund employees did not understanding the technicalities of “hedging”?

How to apply this for an edge

Yield as a time series tends to remain stationary and has a negative correlation to the underlying stock price. Consider selling short when yield gets to a historical low, look at covering when it reverts to mean value; and vice versa for buying and selling.

The chart holds last two years of McDonald’s (MCD) along with its yield. Pretty easy right?

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