I regularly hear or read comments about how the FTSE100 is ‘cheap’ in Dividend Yield terms compared to other Assets and Stock Indexes etc., and I am sure I have generally accepted this as pretty sensible. However, I was reading the excellent Chris Dillow in this Week’s Investors Chronicle (4 March - 10 March 2016, Page 16) under his column headed ‘Yields’ weak signal’ and it made me realise that perhaps this advice is rather more nuanced in practice (as with so many Financial concepts, the Theories we read everywhere are barely workable in practice and often downright false.)
According to Chris’ column and Page 8 of the same copy of Investors Chronicle, the Historic Dividend Yield for the FTSE All Share Index is about 3.86% - which is higher than its average for 30 years of 3.6%. So, on that basis, you can argue that the FTSE All Share (the wider ‘Market’ if you like) is cheap - although I think it is fair to say it is not silly cheap (no great surprise after many years of Share Price rises). Therefore, it looks like we should rush out and buy Stocks because they are clearly ‘cheap’ (a high Divvy Yield is being used here as a Proxy for cheapness - which seems fair enough to me.)
Trouble is, as with anything related to Stocks, it’s not quite that simple - as Chris illustrates in the following text - in the short term, a high Dividend Yield does not lead to higher Share Prices:
“For monthly changes since January 1985, the correlation with the lagged dividend yield is just 0.14, which implies that the yield explains less than 2 per cent of the variation in monthly returns.”
Note that a correlation of 1.0 means that 2 Assets/Items move in lockstep together whereas a correlation of 0 means there is no linked movement (I.e. the Assets/Items move independently of one another). A negative correlation number means that the Assets/Items move inversely (opposite directions) to each other.
However, in the longer term, valuations as expressed in terms of the Dividend Yield do have some predictive effect. Chris goes on to say:
“The correlation between the dividend yield and subsequent annual changes in the All Share is 0.48, and that with three yearly changes is a hefty 0.67, which implies that the yield can explain over two-fifths of the variation in three yearly returns.”
This lines up with the pretty famous Benjamin Graham saying which goes along the lines of “in the short term the Market is a Voting Machine, in the long term it is a Weighing Machine”. In other words, sentiment drives Share Prices in the short term, whereas Valuations (in reality, the Cash that a Stock throws off to Shareholders) drive Prices over the long term.
Chris then adds that in the short term factors like the time of year, i.e. whether Winter or Summer and what month it is, have more effect on the movement of Prices than the apparent cheapness or otherwise of Stocks according to a Market Valuation Metric like the Dividend Yield. For information, he notes that April is historically on average the 2nd strongest Month of the Year, with only December beating it. For the FTSE100, the Average Return is 1.8% and it rises in 71% of years. It will be interesting to see how this April plays out, as clearly there are many Dark Clouds gathering.
This leads me to an intriguing conclusion; in the Short Term Stocks may appear to be in trouble with all the various Bear Market sort of factors we all know only too well - however, on historic precedents, it seems likely that the current Historic Dividend Yield on the FTSE All Share is telling us that over the next 3 years Stocks are likely to do very well. I find that a somewhat surprising idea.
Anyway, in 3 years time I will let you know how it went !!
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