Sep 17th 2011 | from the print edition
EUROPEAN stocks have taken a battering in recent months. The DAX index of German shares has fallen by around a third since May, significantly underperforming the S&P 500.
It only takes a glance through the rest of this newspaper to figure out why. Investors are mesmerised by the inability of European politicians to deal with the sovereign-debt crisis and are worried about the health of the region's banks. Bank shares have fallen back towards their lows during the 2008-09 crisis, a decline that has not been halted by short-selling bans in some parts of Europe.
A sign of this risk aversion is that investors are happy to lend money to both the American and German governments for less than 2% over ten years, yields which suggest that investors are concerned about a deflationary recession. That might turn out to be the right bet. But it leaves a big gap between bond yields and the dividend yields on offer from leading European equities. If you combine the FTSE 100 and Eurostoxx 50 index, some 46 stocks (almost a third of the total) were yielding more than 5% on September 13th and were thus offering an annual income three percentage points higher than that available from safer government bonds.
Eliminate the banks on the ground of riskiness and that still leaves 40 high-yielding stocks. Take an even stricter line and exclude all financials (the insurers and the fund managers) and there nevertheless remain 30 to choose from. Of course, dividend yields are normally high for a reason, the likeliest being that investors expect future dividends to be cut. If Europe suffers from the kind of deflationary slump that bond markets seem to be presaging, then profits would undoubtedly come under pressure.
However, many of the high-yielding equities are in sectors (telecoms providers, power generators, food retailers, pharmaceuticals, and so on) that you might expect to be recession-proof. Some firms, like Marks & Spencer and Royal Dutch Shell, even have earnings that cover their dividend payouts more than twice. Absolute Strategy Research, a consultancy, reckons that European companies have some â?¬800 billion ($1.1 trillion) of cash on their balance-sheets.
Furthermore, when markets do reach a bottom, high-yielding stocks tend to perform best in the subsequent recovery. In the past five recoveries, the return from high-yielders has beaten that from low-yielders by an average of 29 percentage points in the six months after the trough.
The existence of particular shares that look cheap does not necessarily mean the overall European market is a bargain. But there are some signs of general value. The European cyclically adjusted price-earnings ratio (which smooths earnings over ten years) is 12.1, according to Absolute Strategy Research. That ratio compares with one of 20.1 in the United States, as calculated by Robert Shiller of Yale University. French and German cyclically adjusted ratios are close to lows seen in 2008 and the 1970s, reckons Dylan Grice of Société Générale.
The dividend yield for the DAX is 4.4%, more than twice the government-bond yield. The relationship between the dividend yield and the bond yield is one of the most interesting in finance. Up until the late 1950s dividend yields were regularly higher than bond yields, simply because equities were more risky.
At that point, however, the "cult of the equity"? developed. Institutional investors, led by George Ross Goobey of the Imperial Tobacco pension fund, realised that equities offered real income growth and were thus a better match for their long-term liabilities than conventional bonds. Furthermore, pension funds could own a diversified portfolio and thus avoid the risk that dogged private investors, previously the dominant owners of equities: namely, that individual companies could slash dividends or go bust.
From the late 1950s onwards, dividend yields were lower (often a lot lower) than bond yields. But the relationship seems to have been changing again recently. Japan's dividend yield briefly moved above the government-bond yield in 1998 and 2002. In 2008 it repeated the trick and has shown no sign of reversing itself; indeed, the gap has been getting wider. Europe, which faces similar debt and demographic problems to Japan's, may be heading down the same path.
On the other hand, a lot of bad news is already in the price. There will be plenty of investors who figure that the chance to own blue-chip stocks on yields of more than 5% is too good to miss.
Economist.com/blogs/buttonwood
from the print edition | Finance and economics
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