Be wary of this flashing ‘buy’ signal

Amid all the confusion and panic of the last few months, investors are crying out for a clear signal as to which way the market will turn next. One signal the gilt/equity yield indicator has, for much of its life, appeared to offer just that. And right now it's flashing buy'. But should you trust it?

The gilt/equity yield indicator

The indicator is simple enough. Take the dividend yield available on stocks (in this case, the FTSE 100) and the yield available from ten-year government IOUs (we'll use gilts). Divide the gilt yield by the equity yield to get the ratio. Normally you'd expect to get a number above one, because the yield on gilts should usually be higher than the yield on equities. That's because various studies (such as the Barclays Equity Gilts study) have shown that over time equities beat gilts when dividends and capital gains are taken into account. So you'd expect the pure income return on shares the dividend yield to be below the total return from medium-dated gilts, because most shareholders expect to make a capital gain on top.

Indeed, in a bull market the ratio will rise to well above one as investors dump safe gilts (which pushes the price down and the yield up) and pile into equities (which pushes the price of equities up and the dividend yield down). Little wonder, then, that, for the past 50 years, the ratio has averaged two (to translate: the yield on gilts has been roughly double that of equities).

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But this is no bull market. When investors start to dump equities, dividend yields rise as prices fall. As they pile into government bonds instead, the yield falls as prices rise. The combined effect is to drag the ratio down. Fans of this ratio say this process has now gone so far that shares look insanely cheap. The FTSE 100 average dividend yield is sitting at 3.6%. Capita Registrars expects it to hit nearer 3.8% soon, as companies raise their dividend payouts. Meanwhile, the yield on a ten-year gilt is around 2.4%. That puts the ratio at 0.66 pretty much the lowest it's been in half a century. Time to buy?

The bear trap

In short, no. The fact that this ratio is so low tells you more about bonds than equities. Yields on safe government IOUs are at record lows for several reasons. Yes, risk-averse investors have been piling in and depressing the price. But the Bank of England's quantitative easing (QE) has also been wreaking havoc: by buying up gilts, the BoE has squeezed yields even more. A gilt yield that has been artificially suppressed like this can't be trusted as much as it could in the past, because we've never seen these measures deployed on anything like this scale before.

Meanwhile, dividend yields are rising as companies raise payouts to tempt investors. That sounds good, but it's only because capital gains prospects are so poor, due to the weak economy. So that should put you off jumping into anything other than the strongest defensive stocks.

This article was originally published in MoneyWeek magazine issue number 561 on 28 October 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.