Strategy & economics
Dividend yields are higher than bond yields in most major markets. Historically, this has been a reliable "buy" signal. But other measures suggest stocks are not cheap
With the possible exception of President Trump, there are relatively few cheerleaders for US stocks at the moment. The ambivalence is understandable: the bull market has run for a decade, growth is slowing and political risks are rising.
But the sharp rally in global bond markets over the summer is causing some investors to rethink. The S&P 500’s dividend yield of nearly 2% still exceeds the yield on 10-year Treasury bonds. Historically this has been viewed as a reliable buying signal.
Traditionally, investors have expected a higher yield from bonds than equities. This is because equities offer the prospect of capital appreciation – in addition to the ongoing income from dividends. When this normal state of affairs is reversed, it is often interpreted as a signal that equities are undervalued.
US dividend yields were higher than bond yields in both 2012 and 2016. Both occasions preceded big rallies in equities, fuelled in part by low interest rates.
Cheap money helped to stimulate economic activity. It also facilitated a surge in corporate borrowing, allowing companies to buy back billions of dollars worth of stock and boosting share prices. Finally, low interest rates also helped raise equity valuations, as future cash flows are more highly rated in a low interest rate environment.
Despite this track record, there is probably reason to view the signal with a little more scepticism this time round. The latest crossover in bond yields and dividend yields may well be an indication that bonds are overvalued – rather than equities undervalued.
Other valuation measures allow us to assess the stock market’s value independently of the bond market. They paint a much more mixed picture. The most commonly used metric is the ratio of price to earnings (the “P/E” ratio). Comparing the current ratio to history provides some insight into how cheap or expensive a market is.
Currently, US equities trade at close to 18 times the profits they are expected to generate over the next year; globally, the figure is closer 16. In both cases, this is at the high end of the range over the last 15 years.
On this basis, it is hard to argue that stocks look particularly undervalued. The last two occasions on which dividend yields exceeded bond yields, the P/E ratio was much lower than it is today – and it was easier to make the case that stocks were cheap.
The US appears expensive, Japan appears cheap...
Source: Bloomberg, Cazenove Capital, September 2019
Registering historic lows
Source: Bloomberg, Cazenove Capital, September 2019
An interesting feature of today’s market is the very wide range of valuations – with some sectors or countries extremely highly valued while others appear cheap.
At the sector level, industries with strong growth prospects, such as technology, and those that are perceived to be less economically sensitive – such as consumer staples – command high valuations. Those that are more cyclical – including financials and energy – trade at a much lower rating. The disconnect is the widest it has been in many years.
The low valuation of cyclicals reflects the persistent fear that the current business cycle is finally set to turn. Nobody wants to get caught with companies that will bear the brunt of a recession. Defensive and high growth sectors, on the other hand, are viewed as safer.
The former, which include stalwart dividend payers like Johnson & Johnson, offer prospects of stable earnings that should hold up in a recession. Meanwhile, against a slowing economic backdrop, sectors that can reliably deliver growth are in high demand. That some of these companies may not generate profits or cash flow for years to come is less of a concern when interest rates – effectively, the “time value of money” – are so low.
This is one factor which explains why different stock markets also trade at very different valuation multiples, as illustrated in the 'stock valuations by region' graph. The US, which is home to technology giants such as Amazon, trades at a significantly higher multiple than many other markets.
There are other factors that explain valuation differences between national markets – and that support higher valuations for some.
The first of these is profitability. When companies are generating higher profits, they are better placed to cope with a tougher economy and invest in new business opportunities. In other words, they combine lower risk and higher growth – both of which justify higher valuations. US companies, in particular, find themselves in this situation today.
Inflation is another factor.
P/E ratios tend to be highest in periods when inflation is close to 2% and appears to be on a predictable trajectory. The ratio tends to drop where inflation is higher or lower. The sweet spot, just below 2%, is where the US finds itself today. At current, low levels of inflation, central banks face little or less pressure to raise interest rates, while companies have some flexibility to increase the price of their goods without costs spiralling out of control.
If anything, the danger is that inflation is too low. That is one message from the low bond yields we are seeing around the world. A deflationary environment is not good for stocks; companies lose pricing power and must contend with a higher real burden of debt.
The Japanese market is often cited as an example of this. Japan's P/E ratio was very high in the 1980s but has fallen steadily since then, as inflation has turned into a protracted bout of deflation. Today, Japanese stocks trade on a multiple of 13, the lowest rating in years.
Overall, we don’t think equities look particularly cheap on a standalone basis, even if certain sectors and countries appear attractively valued. We aim to ensure a balanced exposure to both higher growth investments and more cyclical ones. While it can be tempting to favour unloved sectors or geographies, they have already been out of favour for much longer than anyone expected. This could well continue.
This article is issued by Cazenove Capital which is part of the Schroder Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. All data contained within this document is sourced from Cazenove Capital unless otherwise stated.