In these uncertain times equity investors have one big comforting fact they can cling to – that UK equities are cheap by one obvious measure. The dividend yield on the All-Share index is now 4.1 per cent, well above its post-1987 average of 3.5 per cent.
For short-term investors, this isn’t much help: the correlation between the yield and returns in (say) the following month has been small. But the longer your time horizon, the more important the dividend yield is. Since 1987 it has on its own explained one-fifth of the subsequent variation in annual returns, and more than two-fifths of the variation in three-yearly returns.
If past relationships continue to hold, the yield points to the All-Share index rising 30 per cent over the next three years, with only a 6 per cent chance of it falling.
You might think this is trivial. It’s only saying that cheap markets eventually recover and expensive ones fall. Big deal.
Not quite. This fact is not so true of many stock market sectors. Whereas a high yield (relative to its past) predicts good returns on the market generally, high yields on many sectors do not predict high returns. What’s true of the market as a whole is not true of its components. There’s even a name for the belief that this is the case – the ecological fallacy. It’s closely related to Simpson’s paradox – that what is true of a sample of data is not necessarily true of sub-samples of it.
For example, whereas variations in the dividend yield explain 42 per cent of the variation in three-year returns on the All-Share index since 1987, they explain less than 10 per cent of the variation in three-yearly returns for mining, banking, IT, construction or engineering stocks.
For most sectors, the fact that yields are high relative to their average is therefore no good reason to buy, nor are low yields a strong reason to sell.
One reason for this is simply that reratings and de-ratings can last a long time: in fact, they can be permanent. This is clearly true for individual stocks: those of you who bought Carillion or Debenhams when its yield looked high don’t need reminding of this. But it’s also true for sectors generally. Tech stocks, for example, looked expensive in the mid-to-late 1990s, but they got even more expensive. Conversely, food retailers seemed cheap in 2013 – but got even cheaper.
Also, a high yield can be a sign of especial risk. This will produce high returns if the risk doesn’t materialise, but big losses if it does. In early 2008 construction and mortgage lending stocks were on high yields, but they subsequently crashed.
For particular stocks or sectors a high yield can be a warning that dividends are about to be cut. For the market as a whole, this is less likely. A high yield is therefore a more reliable signal for the aggregate market than it is for particular stocks or sectors. This is another way of expressing Paul Samuelson’s saying – proven for US shares by Robert Shiller – that the market is “micro efficient but macro inefficient”. Whereas the aggregate market can overreact – causing a high yield to predict good returns and a low yield bad ones – individual stocks are less likely to do so.
All that said, there are a few sectors where yields have predicted returns over the past 30 years. One is food manufacturers. Here, however, yields are now below their long-term average, which is a reason for caution.
Another sector is utilities. Yields here are now well above their long-term average, which would ordinarily be a buy signal. Personally, though, I wouldn’t bet on this. High yields are a sign of unusual political risk – the danger that these companies will be nationalised or regulated more heavily. Yes, they’ll deliver good returns if this risk doesn’t materialise. But that’s a risky bet.
Another sector where yields are high and a predictor of returns in the past is general retailers. Again, though, these are risky. With consumer spending likely to be weak in coming months, can we really be confident that all the bad news for the sector is more than fully priced in?
This raises the question. If shares are cheap on a medium-term view – as the dividend yield suggests – what should we buy, given that yields don’t tell us much about particular sectors?
The answer is simple but dull: tracker funds. One underappreciated case for buying these is simply that the aggregate market is, at least in the medium term, a little more predictable than individual stocks.
