Why Are Stocks So Cheap?

Why Are Stocks So Cheap?


By Financial Times 08-24-10 12:15 AM

By James Mackintosh

Which would you prefer: a regular income likely to rise at least as fast as inflation or a lower fixed income with no prospect of increases? Put like this, equities look appealing.

The simplest measure of shareholder value--the dividend yield--offers a higher income than government bonds in the UK, Europe, Japan and now also the US, at least for the Dow Jones Industrial Average. Dividends on other US indices remain lower than bonds, but the Dow is higher for only the second time in the past 30 years (the other was after Lehman collapsed).

Historically, high dividend yields have sometimes been a great indicator of buying opportunities, not just in the West, but also, as Morgan Stanley points out, the deflationary Japanese market. The lesson from Japan in 1998 and 2003 repeats that of, for example, Britain in 2003, when investors who bought when the dividend yield passed the bond yield timed the bottom of the market almost perfectly.

Unfortunately, times may have changed. High dividend yields could be saying stocks are cheap. Or they could be telling us profits are too high and dividends will fall. In an indebted West full of savers rather than spenders, the latter is at least plausible.

There is also a question of investor mindset. The dividend yield is inherently uncertain, while government bond yields come with the best guarantees available. Rather than focus on the returns available from dividends--and risk-taking in general--many investors currently prefer to be sure they will get their money back. If that resistance to risk persists, the investment world would look more like that prevailing before the mid-1950s, when shares yielded more than bonds.

If this is the case, a different Japanese lesson may be appropriate. Investors who bought in early 2008, when the dividend yield again passed that from bonds, are still waiting for a rally. At least in the meantime they can collect their divis.