Bright spot

tauringhuang.

Sep 21st 2008
From Economist.com

British equities look promising


BARGAIN hunters in equities will have noticed an encouraging sign last week. On September 17th, the yield on British equities, as measured by the FTSE All-Share index, was higher than the yield on 10-year gilts (see chart). This last happened in March 2003, just at the start of a rally in the London market that saw it double over four years.

Why does this matter? Dividends grow over time whereas the interest on government bonds is fixed. Admittedly, a good deal of dividend income comes from the banks, which will cut their payouts. But oil and telecom companies are also good payers, and across the entire market, dividends are more than twice covered by profits.

When equities yield the same as gilts, the market is essentially betting that there will be no dividend income growth over the medium term. Or to put it another way, it is demanding a very high risk premium for investing in equities.

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Up until the 1950s, it was quite common for equities to yield more than gilts. That was because most shares were owned by individual investors, who were exposed to the risk that an individual company might fold. That changed with the “cult of the equity”, which saw pension funds move heavily into the stock market; their large portfolios diversified away the risk posed by any single company failing. The yield on equities fell below the yield on gilts in the late 1950s and stayed there for decades. Indeed, it was a rule of thumb in the 1980s and 1990s that equities were cheap when they yielded more than half as much as gilts.

But is this relationship theoretically sound? Sharp-eyed readers might have spotted similarities with the so-called “Fed model.” Wall Street traders relied on it in the 1990s but it let them down during the dotcom bust. This compared the prospective earnings yield on the S&P 500 (the inverse of the price-earnings ratio) with the yield on Treasuries. When the former was above the latter, shares were perceived to be cheap.

The problem with this approach is it compared a real asset (equities) with a nominal one (government bonds). Equities are a claim on a company’s revenues, which rise (over time) with inflation; bonds are fixed in price. Secondly, if bond yields fall, is this good news for equities? Either it means that inflation is expected to fall, which means that nominal profits growth will fall as well, or it means that economic growth is expected to decline, which means that real profits growth will also decline. In Japan, the slump in government-bond yields that occurred during the 1990s was not a good sign for the stock market.

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So it would be unwise to mortgage your grandmother to buy British equities on the back of this latest signal. Nevertheless, while it may have been coincidence, the FTSE 100 index achieved its biggest-ever rally on September 19th, rising 8.8%. And there are one or two other bullish indicators. The price-earnings ratio on the all-share is only a little over 10; single digit p/es have proved good long-term buying opportunities in the past. By Wednesday’s close, share prices were still 30% down from the peak reached at the end of 1999.

Perhaps the best way to look at the market is to look at the risk premium. Over the very long run, one would expect dividends to grow in line with nominal GDP, which ought to be around 4.5% a year (assuming real growth of 2.5% and that the British government meets its inflation target). So with equity yields above bond yields, that suggests a risk premium of 4.5-5%, slightly above the historical average. That looks an appealing bet for those with a sufficiently long (years, not months) time horizon.