Dividends await despite the signs

7 December 2009 | By Tom Elliott

Tom Elliott is a global strategist at JPMorgan Asset Management

Looking at two of the most widely used metrics for valuing British equities—the historic, or trailing, price/earnings (P/E) ratio and the dividend yield relative to gilts—equities appear reasonable value.

This is despite the sharp rally that we have seen since March, which followed an unusually bleak moment in financial history, with fears of depression and deflation scaring investors. This article focuses on the British market, but the arguments can be applied to many overseas markets as well. (article continues below)

The most striking aspect of the British stockmarket’s recent history is not its historic P/E, which is at long-term average levels, but where it came from.

The chart (top) shows that the P/E on the British market fell to just above six times in March 2009, the lowest for at least 20 years, as investors began to fear that the recession would lead to depression. The subsequent rally has more than doubled the P/E, to over 16 times, as investors came to appreciate that massive monetary and fiscal stimulus meant a slide into depression became less likely.

Yet despite the doubling of the P/E, the market is priced at a similar level to where it was at the start of the 1990s rally, in March 1993, and where it was in March 2003, when the last bull market started.

At first glance it may seem odd that a market can be at a long-term average P/E ratio so early in a stockmarket recovery. The answer is that it is normal for a bit of P/E inflation at the start of a new economic cycle, as investors price in economic recovery, raising the “P”, while the effects of recession on the last earnings statement show up in a low “E”. P/E ratios do not automatically increase as a stockmarket rally occurs; as the chart shows, we had a falling P/E from 2003 to 2007 on the British market while share prices steadily rose.

”Interest rates in Britain and other main economies are likely to remain low for an extended period”

If historic P/E ratios can be accused of being misleading, because of the recession-effect on earnings, so forward P/E ratios can be accused of being misleading owing to the difficulty of making earnings forecasts for years ahead, at such an early stage in the recovery. Either method is likely to conclude that valuations are reasonable, but by no means cheap.

Since 1957, the British stockmarket has priced the gilt yield higher than the dividend yield.

The second chart shows that during the recession, when fears of depression were frightening investors, the dividend yield on the British market returned to its pre-1957 relationship with the gilt yield. Investors wanted extra protection in the event of corporate failure, while gilts appeared more attractive as fear of depression and of deflation increased.

As stockmarket sentiment improved from March, the relationship has shown signs of returning to normal, with gilts once again yielding more than dividends.

But the difference is slight, and the suggestion is that there is further for it go, with either the dividend yield falling further (as stockmarkets rise), or gilt yields going up (as growth and inflation concerns pick up).

This observation is predicated on a belief that we will avoid a depression in Britain. Consensus forecasts, from Bloomberg on November 17, suggest the UK will see GDP growth of 1.1% in 2010 and 1.9% in 2011. While this suggests a weak recovery in output, a recovery it is.

You do not have to believe in the Bank of England’s own forecast for GDP growth of 4% in 2011, in its November inflation report, to see that we are in an environment where equities should probably not be priced the same as bonds.

But the most compelling argument for equity dividends is not against gilts but against bank account cash. Interest rates in Britain and other main economies are likely to remain low for an extended period of time.

The market expects a rise in rates over the next 12 months, with consensus expectations at 1.25% by the end of 2010, according to Bloomberg—a steep rise from today’s 0.5%, but still very low relative to history.

This makes dividend yields look attractive for income seekers, particularly given that much of the yield from the market comes from defensive sectors that have underperformed the market year-to-date, thereby offering some protection in case of market nervousness following the debt problems in Dubai.

In summary, the historic P/E of the British stockmarket is reasonable and does not, by any means, preclude further gains.

However, the main attraction of equities is perhaps the dividend yield, which is attractive relative to its historical relationship with the gilt yield, but is most compelling when compared with bank account cash rates.