Interest Rates, Dividends, and Equities
by George Hatjoullis
Healthy markets normally exhibit a range of opinions. It is when everyone seems to hold the same opinion that I get worried. Of course, a strong consensus within one asset class does not imply a consensus across asset classes. For the investor taking a portfolio approach it is always necessary to look across asset classes and compare relative value. I hope the significance of this statement of the obvious becomes clear as the blog unfolds.
The problem facing investors at the moment is that unprecedented easy money has generated inflation. Unfortunately for policy makers, the target inflation was for goods prices and the actual inflation has emerged in asset prices. This has been good for those owning assets but not so good for those with debts. The asset owners, or investors, now own what increasingly look like overvalued assets. However, though all asset classes have been inflated not all have been inflated by the same amount. There is still a relative value decision for investors to make.
As a sweeping generalisation (we bloggers love to make these) I would assert that bonds and retail property are now seriously overvalued. In the case of retail property the assertion is easy to justify by looking at property prices relative to average incomes. In the case of bonds there is a direct causal link to easy money so it is self-evident (unless you believe easy money is a permanent phenomenon). The valuation of equities is more difficult. In absolute terms one can make a case for equities being poor value. In relative terms, however, one can make a case for equities being cheap. Finally, cash is neither cheap nor dear though I would argue it is quite hard to find!
In asset allocation terms I would hold zero bonds right now if I could hold only cash. This is more difficult than it sounds. I do not want to make a loan to a bank and the insured deposit amount is only £75k in the UK. To hold cash one must either spread across many banks or use National Savings, neither of which is a user-friendly option. Like most people who live in London and own a house I am heavily weighted in retail property. However, I am underweight commercial property and equities.
So why do I think equities are relatively cheap? The best easy access cash deposit I can find presently pays a variable rate of 1.20% p.a. However, it is not difficult to construct a diversified portfolio of equities yielding 5%. The diversification is in terms of a range of industries. It is clearly concentrated in relatively high yielding stocks, so it is a qualified diversification. The portfolio offers a 3.8% advantage over cash. Now neither dividends nor the interest rate on cash are guaranteed. However, if they stay the same over 5 years the portfolio of equities will outperform by 20.5%. If they stay the same over 10 years the portfolio of equities will outperform by 45.2%. The power of compound interest!
Over the course of 5 or 10 years a lot can happen and equity prices can fall. They can fall by as much as 45% or more. Dividend yields can fall also. However, dividend yields and equity prices can also rise and invariably rise some after a fall. Equities are risky but they offer a risk premium of 3.8% (or more or less depending on how you construct your portfolio). Is this an adequate risk premium given the risk? This is a personal judgement but history would suggest it is not bad!
This does not imply that one should mortgage the house and put everything in equities. It does however suggest that owning some equities here makes sense in a balanced portfolio with enough cash to ‘average in’ if equities do sell off. Moreover, if equities continue to rally the equity proportion of your portfolio will adjust naturally!
What might make equities sell off? Many seem to think interest rate increases would do the trick. Oddly, the only major market making new all time highs is the US and interest rates are rising in the US. Interest rate increases per se are not a problem. It depends on the context, pace and so on. As I have argued in a recent blog (The Uncertainty Paradox) raising rates could even help by resolving uncertainty. Generally markets sell off when they run out of new buyers and a few canny (big) investors see a chance to push the market lower to buy back cheaper. There is also a natural psychological tendency to ‘take profit’ after a good run. Are we at this point? Who knows and for the portfolio investor that has no stomach for ‘timing’, it does not matter.
The portfolio investor recognises markets go down and up and that they have no capacity to predict direction above the general expectation that equities tend to go up in the long run (whatever this might be). The portfolio strategy should always be structured around this expectation. The rest depends upon personal circumstances.
An equally weighted portfolio of the following 15 stocks would yield materially over 5% making up for any initial transaction costs: HSBC, Vodafone, BP, RTZ, Glaxo, M&S, Pearson, Carillion, British Land, Sainsbury, Legal & General, Royal Mail, Standard life, SSE, Centrica. It is one per industry though with some overlaps. Standard Life is primarily a fund manager these days with L&G also having more traditional insurance business. M&S and J. Sainsbury have some food correlation. Centrica and SSE also overlap though Centrica is quite diversified in services.