The recent sharp fall in stock markets has left many shares looking cheap. This can be a dangerous snare, and not just because in fast-moving markets the old saying is true: 'never try to catch a falling knife'. It’s also because stocks are sometimes cheap for a reason: a high yield is often a sign of poor growth prospects or of extra risk – and risks can sometimes materialise.
Which poses the question: when is an unusually high yield a sign of a bargain, and when not? My table helps answer this question, and shows something worrying.
It shows correlations since 1999 between the dividend yield for particular FTSE sectors and price changes on those sectors in the subsequent 12 months. If yields predict returns, we’d expect to see highish correlations.
| Correlation between yield and subsequent returns | |
| Healthcare | 0.55 |
| Aerospace | 0.52 |
| All-Share index | 0.48 |
| Support services | 0.47 |
| General retailers | 0.46 |
| Pharmaceuticals | 0.44 |
| Tobacco | 0.41 |
| Construction | 0.19 |
| Utilities | 0.15 |
| Banks | 0.12 |
| Chemicals | 0.05 |
| Food retailers | -0.12 |
| Based on annual returns since 1999 | |
For the All-Share index, the correlation is 0.48. This tells us that above-average yields have more often than not led to above-average returns on the index in the following 12 months. And it means that variations in the dividend yield alone explain around a quarter of the variation in subsequent annual returns. Those of you with a physics or engineering background might think this correlation low. But by the standards of financial economics it is actually quite high. If the dividend yield didn’t predict returns at all, the correlation would be zero.
And, in fact, for some sectors it pretty much is – such as banks, food retailers and non-life insurers. For many others, the correlation is less than 0.3, meaning that yields explain less than 10 per cent of the variation in subsequent returns.
This warns us that unusually high yields are often not a buying opportunity but – almost as often – instead a sign of genuinely worse growth prospects.
In 2007, for example, banks were on decent yields. But they subsequently crashed. Their high yield foretold not high returns, but rather warned us of a high risk – which materialised all too nastily. In 2015, miners were on good yields, but they fell in the following 12 months. Conversely, construction stocks were on low yields in 2016 as were food retailers in 2017, but both subsequently did well. There are so many cases such as these that they warn us that an unusually high yield on a stock is often not a buying opportunity.
Yes, any positive correlation at all means that an above-average yield is more likely than not to lead to above-average annual returns. But a correlation close to zero means the odds aren't much better than 50:50.
Dividends yields, then, help predict returns on the market as a whole, but not so much returns on many sectors. If this sounds surprising, perhaps it shouldn’t be. It vindicates an old saying of Paul Samuelson’s, that stock markets are “micro efficient but macro inefficient”.
One reason for this is that it is easier for investors to assess the prospects for individual companies and therefore for all relevant information to be embedded into prices as efficient market theory says it should be. It is, however, much harder for the aggregate market to price in all relevant information about the future because there is so much of it, and because groupthink and professional deformation prevent investors in aggregate from properly processing it all.
Also, it is often easier to short sell a particular stock than the whole market because one can sometimes lay off the bet by going long of a comparable company of whom you are bullish. It’s much harder to do the same for entire markets.
There are, then, good reasons why the market should be macro inefficient but micro efficient.
The real world, however, is usually messier than any single theory or saying. There are some exceptions to this pattern. For a few sectors, yields do help us predict returns.
Two of these are aerospace and support services. Sadly, though, yields here are actually slightly below their average, so this is no help for investors.
Nevertheless, there are some sectors where yields have predicted returns and which are now on above-average yields. These include healthcare, pharmaceuticals, tobacco and general retailers. If history is any guide, investors might now be too pessimistic about prospects for these sectors and so are underpricing them.
Of course, history might not be a guide. But the evidence base for being income investors in these sectors is perhaps stronger than it is for other segments of the market.
