Snap! – yields and total returns from equities can only move in opposite directions for so long

By Kevin Murphy.

Over the course of 2011, company dividends across the UK market – if one excludes special payments and the distorting effects of BP’s return to the register – rose by about 12% and yet the market fell 8%. Despite this rise you need to remember that past performance is not a guide to future performance and may not be repeated. When dividends head so decisively in one direction and share prices in the other, that is evidently telling us something. What exactly?

First it tells us that, despite reasonable fundamentals and exceptional dividend growth in the context of history, people were not interested in owning equities – and they were not interested because of the uncertain economic environment.

The second and more interesting point is that last year’s performance is a reminder of how the elastic band that is valuation can only stretch so far. Dividends are currently forecast to grow about 8% over 2012 and, should capital values remain unchanged, that would again represent a significant hike in equity yields. Eventually, enough is enough and the elastic band suddenly snaps back. Nobody can know exactly when that will happen but, when it does, it can lead to some extreme market moves.

One month into the New Year, equities have done quite well. While one would not want to extrapolate anything from that, at some point the elastic band is going to begin its return journey. With the natural caveat that the collapse of the euro would cause equities to come under pressure, the valuation discrepancy between them and other asset classes is extreme while current forecasts for dividend growth in the context of history remain attractive.

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