- The dividend yield predicts lacklustre returns on equities, but retail sales send a more bullish signal.
- An upward-sloping yield curve is also a slightly bullish signal.
Which message do you believe – that from equity valuations or that from consumers? This matters for where you think the market is heading?
Valuations are sending a worrying message. At just over 3.1 per cent, the yield on the All-Share index is a little below its 25-year average (of 3.3 per cent). If history is any guide, this points to poor returns on equities over the next three years – albeit probably inflation-beating ones.
Consumers, however, are sending a cheerier message. Although retail sales have fallen since June the ratio of sales to the All-Share index is still above its 25-year average – a fact which in the past has predicted good returns on equities.
There’s a simple reason why it does so. Consumer spending is in part forward-looking: if we expect a big pay rise we spend more than if we fear losing our job. Of course, any individual’s expectations might be wildly mistaken. But across millions of us such mistakes are likely to largely cancel out. High spending in aggregate therefore often predicts good economic times – which are circumstances in which stock markets do well. Equity investors do not price in this message of consumer spending, perhaps because they fail to anticipate that better times will increase their taste for risk. For this reason US economists and researchers at the Bank of England have found that consumer does indeed help predict equity returns.
Which is good news. The above-average ratio of retail sales to the All-Share index predicts above-average returns on UK shares over the next three years.
Hence my question: should we believe the bullish message of consumer spending, or the more cautious one of valuations?
My chart shows the historic forecasting record of the two. They have been generally very similar. Both correctly told us that shares were cheap in 2003 and 2009 and that they were expensive in 2000 and 2007 but neither, understandably, predicted last year’s pandemic-induced losses.
Overall, though, retail sales have done a slightly better job of predicting returns than have dividends. They’ve explained 57 per cent of the variation in subsequent three-year changes in the All-Share index compared with 49 per cent for dividends.
What’s more, just before the pandemic the dividend yield did a poor job. In December 2016 it predicted that the index would rise over 20 per cent by December 2019. In fact, it posted a lacklustre gain on only 8 per cent. UK equities seemed cheap in 2016-17 but their subsequent performance wasn’t as good as such cheapness suggested. Retail sales, on the other hand, predicted returns nicely until the pandemic struck.
Does this mean we should discount the downbeat message of valuations and heed instead the more bullish one of consumers?
No. For one thing, just because an apparently cheap market did not rise does not mean that an expensive one cannot fall. And for another, it’s possible that retail sales have been high recently not because we’ve been anticipating good times but because we’ve been catching up on spending we couldn’t do during the lockdown: the fact that the post-lockdown bounce in spending has been less than some expected does not overturn this possibility.
We should, therefore, be more wary of equities than a simple reading of the retail sales predictor would suggest.
Luckily, though, there’s another reason for optimism, because there’s another indicator which has done a decent job of predicted returns in the past. It’s the shape of the yield curve. Since 1996 the All-Share index has risen by an average of 20 per cent in the three years after 10-year yields have been above three-month money rates. But it has fallen by an average of 7.1 per cent in the three years after three-month money rates have been above 10-year yields. Inverted yield curves in 2000 and 2007, for example, correctly warned us of impending falls in equities.
This indicator works for much the same reason that retail sales do. An upward-sloping yield curve predicts better economic times (because it predicts rising yields) and an inverted curve worse ones.
With 10-year yields now comfortably above three-month rates, this points to equities doing well. Like the others, it is not perfect: the historic pattern points to around a one-in-six chance of the market falling over the next three years. No indicator (and no pundit either) can predict bolts from the blue such as last year’s pandemic. It is, however, a reason for moderate and cautious optimism.
