Dividends are reassuringly honest. Companies can massage their earnings but the amount they pay in dividends is clear-cut and unarguable. So in times of uncertainty, dividends come under scrutiny, notes John Authers in Tuesday’s Short View column.
Profits, many believe, are about to fall off a cliff. In the financial sector, they already have. Dividend yields tend to be much “stickier” – companies are loath to cut them.
When profits are falling, buying stocks with a high dividend yield can be one of the best ways to spot stocks that are truly cheap, while stocks which look cheap because of low price/earnings multiples often prove to be traps once earnings fall. Société Générale research confirms that in January, strategies based on high dividend yields beat those based on a low p/e.
A second reason to look at dividend yields is that they form an ultimate backstop to the value in stocks. Dividend yields should almost always be lower than the yield on fixed income government bonds. Dividends have the potential to grow, unlike the coupon on bonds.
If dividend yields exceed bond yields, that tends to signal that equities have reached a trough. In the past 20 years, the dividend yield on the S&P 500 exceeded the two-year bond yield for only about a year. That was from 2002 to 2003, closely matching what turned out to be a bottom in the market.
According to Datastream, S&P ended last week yielding 2.08 per cent; two-year bonds yielded 2.09 per cent. Other indices look cheaper: the FTSE 100 has a yield of almost 4 per cent while the MSCI World is yielding 2.56 per cent. Could this mean the market has hit rock bottom?
Sadly there are other possible explanations. One is that things are so bad that the market is braced for dividend cuts.
Another is that this is a signal to sell Treasuries rather than buy stocks. They have benefited from a huge flight to quality and may be overpriced.