After witnessing three years of falling stock markets, investors are justifiably asking whether equi...
After witnessing three years of falling stock markets, investors are justifiably asking whether equities are now cheap.
A simple look at investors' favourite yardstick, the P/E ratio, would suggest not. While the current P/E ratio on the FT All-Share index, at 19, is lower than it has been since 1999, it is still higher than it ever reached in the 20 years previous to 1999.
More interesting than the UK market's P/E ratio is the current dividend yield, which stands at 3.5%. For investors wondering whether to take out a mini or a maxi Isa, that should look fairly attractive.
But the dividend yield does not tell the whole story. In the 12 months to the end of September last year, UK quoted companies paid out £41bn in dividends. But they also distributed £9bn to shareholders by repurchasing their own securities.
In other words, share buybacks are now an important part of shareholders' income. Allowing for buybacks, as well as dividends, pushes the income yield on the UK market up to 4.25%.
An income yield of 4.25% compares favourably with the 4.5% yield offered by a 10-year gilt. While the payments to a gilt investor are fixed, UK companies should be able to increase their dividends over time, at least in line with inflation if not in line with the real growth rate of the economy.
The UK market therefore offers investors good value. If interest rates were to rise, equities would lose only some of their appeal. And a sharp rise in interest rates and bond yields looks unlikely.
The price of money-market futures implies investors do not expect the Bank of England to raise interest rates until next year. Household spending, which has propped up the economy for the past five years, is now growing no more quickly than household earnings.
With the UK's trade performance and corporate investment still a drag on growth, the UK economy is likely to grow by only about 2%, much less quickly than is necessary to stoke up inflation. Consequently, the Bank of England is unlikely to feel in any hurry to tighten policy.
It is not just the UK equities that are attractive ' European markets also look oversold. Like the UK, the French and German markets look too cheap when compared with yields offered by domestic bonds or money-market investments.
The weak economic environment in continental Europe however, suggests that bargain hunters should approach these markets with caution.
In contrast to the UK and the US, household spending remains stagnant ' activity is still heavily reliant on overseas rather than domestic sales.
In particular, household spending on big-ticket items remains depressed and firms' stocks of unsold goods are growing. It is not surprising, therefore, that European analysts are especially pessimistic about the profit outlook for their markets.
Equity markets have been sold off too far, and should reward investors with double-digit returns this year. However, any sustained rally may have to wait until the prognosis for the world economy improves.
Equity markets sold off too far.
Double-digit returns expected this year.
Sharp interest rate rises look unlikely.
Moves to overweight equities and fixed income
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