For years, some economists have worried that low interest rates are encouraging a 'reach for yield' – a hunt for income-paying assets that has caused them to become overpriced.
Many of you must be thinking 'if only'. Instead of benefiting from a 'reach for yield' several equity income funds have done badly recently and most have underperformed the All-Share index in the last 12 months.
The problem here is not just that fund managers have picked the wrong stocks. It’s that income stocks generally have derated.
One measure of this is the yield on the FTSE 350 higher-yield index. Since May, it has risen from 4.7 to 5.1 per cent, as higher-yielding shares have underperformed the market. What’s more, the gap between the yield on the higher-yielding index and that on the FTSE 350 lower-yield index is now three percentage points. That’s one standard deviation above its post-1990 average. By this measure, income stocks are cheap relative to growth stocks.
My chart puts this derating of income stocks into historical perspective. It shows that there have been three peaks in the yield gap between income and growth stocks: the recessions of 1991-92 and 2008-09, and in 2015-16 when mining stocks sold off. Conversely, the gap was low in the good times of the late 1990s and mid-2000s.
Yield gap between income & growth stocks
This tells us that there’s an element of cyclicality in the yield gap between income and growth stocks. In bad times, income stocks get derated relative to growth stocks.
The poor performance of income stocks and funds might, therefore, be a symptom of pessimism about the economy’s near-term prospects.
Which poses the question: does this yield gap tell investors anything about the future?
Yes. If we control for the All-Share’s dividend yield, a high-yield gap leads to the stock market falling. For example, the gap was high (relative to the dividend yield) in 2000 and 2010 and equities did badly in the following 12 months. But it was low relative to the market’s dividend yield in late 2008 and shares subsequently rose strongly.
I suspect this is because the yield gap is a measure of investors’ sentiment. It’s often the case that the gap is high when growth stocks are highly valued – when these are on low yields. But overoptimism about growth stocks is often a sign of overoptimism about equities generally.
For the same reason – and less surprisingly – the yield gap also predicts relative returns on income and growth stocks. A high-yield gap leads to income stocks outperforming growth in the following 12 months, and a low gap leads to growth stocks outperforming income stocks.
All this is encouraging for those of you nursing losses on income stocks and funds. It points to these doing relatively well in coming months, unless the economy slips into recession. If post-1990 relationships continue to hold, they point to the FTSE 350 higher-yielding index outperforming the lower-yield index by around nine percentage points over the next 12 months.
This is because whereas income stocks now yield more than their long-term average, growth stocks yield less.
There is, though, a big caveat here. The yield gap is a stronger predictor of growth stocks than of income stocks, and points to the latter struggling over the next 12 months. All this is more a case for being underweight in growth stocks than being overweight in income.
You might have an objection here. Income stocks should be highly priced now simply because real long-term bond yields are negative. This is because negative yields mean we attach a negative discount rate to future cash flows – implying they are more valuable than current cash flows. Because growth stocks offer more future cash flows than income stocks, they should therefore be highly rated. There should, therefore, be a high-yield gap between income and growth stocks.
I’ll concede that this could explain why the yield gap has trended upwards since the early 2000s. It is, however, inconsistent with two other facts.
One is that growth stocks aren’t massively highly priced – certainly not as much so as you’d expect if future cash flows really were negatively discounted.
Secondly, there’s no sign of any breakdown since 2000 in the correlation between the yield gap and subsequent annual returns on income stocks relative to growth. If a falling real bond yield had caused a rerating of growth stocks, we’d expect to have seen such a breakdown.
I suspect, therefore, that growth stocks’ high valuations relative to income stocks cannot be justified by negative real bond yields. Which makes me suspect that they might well be heading for the sort of underperformance predicted by the high-yield gap. Perhaps, therefore, income investors should hang on in.
