Worrying records in the markets

the jonathan davis column

Another week, another record-breaking merger, another stock market peak on both sides of the Atlantic. The bull market is certainly moving from the impressive to the awesome stage. It is less than 18 months since Alan Greenspan, the chairman of the Federal Reserve, warned about "irrational exuberance" in the stock market. Since then, share prices have risen by around 40 per cent, with the mighty bull trampling all before it.

Clearly, the latest mega-merger in the financial sector marks a new milestone, but quite what it foretells is not immediately clear. The get-together between Citicorp and Travelers Group will create the world's largest single company by asset value. Given that most corporate strategies are driven by emulation, it can only reinforce the trend towards consolidation in the financial sector in Europe.

Of course, in aggregate and over time, bouts of mega-mergers tend to leave shareholders nursing a nasty hangover. In practice, many of the promised synergies fail to materialise. But one can hardly blame the managements of the big banks for opting for such grandiose visions at this time. News of the Citicorp/Travelers deal added more than 20 per cent overnight to the combined market capitalisation of the two companies, echoing the experience of many previous deals in the sector (Lloyds/TSB being a good example from the UK).

If investors were to beg publicly for more such deals to take place, they could hardly have given a clearer signal. What is striking is how the current enthusiasm for merger activity contrasts with attitudes just a few years ago. Then, most investors were trying to rein in managements. The whole "shareholder value" movement began as an attempt to put the brakes on corporate aggrandisement. Now, it is having the opposite effect.

Time will tell whether the trend towards consolidation is well founded in industrial logic and works to the long-term benefit of shareholders. As the New York economist, Peter Bernstein points out, the shift in attitudes ties in to the highly stretched valuations of the main stock markets at the moment. As has been widely observed, the bull market has driven the dividend yield on the American stock market (now 1.6 per cent) to just about its lowest recorded level. (In the UK, the market yield is much higher, at 2.7 per cent, but still well below the long-run historical average.)

That is a warning sign in itself, although there are extenuating circumstances in the form of the high level of share buy-backs and special dividend payments. Just as interesting is the fact the payout ratio - the amount of corporate earnings which are paid out in dividends - has also fallen to its lowest post-war level (35 per cent). At the same time, the value which the market accords to future corporate earning power (the p/e ratio) is at or near record levels - 30-times historic earnings in the US market, 22 times for the FTSE 100 index.

Together, these factors amount to a huge - possibly unprecedented - vote of confidence by investors in the competence of corporate management. In the old days, the ability to pay a good dividend was seen as the benchmark of a sound company, and the payout ratio as a good proxy for management's confidence about the future prospects of the business.

Analysis of past data shows that the dividend payout ratio has been a very good indicator of future corporate profitability. The higher the payout ratio, the faster earnings have tended to grow over the subsequent five years, and vice versa. By that token, its current record low is a warning signal: it means earnings in five years' time will be lower than they are today - not something which is factored in at all in current market thinking. Looked at another way, the value of reinvested dividends has always accounted for the lion's share of the total return earned by investors. But no longer.

The lower the dividend yield and the dividend payout ratio, in effect, the less investors are relying on hard cash today, and the more they are relying on future projected earnings and high market-multiples to make up their expected return from the stock market.

This inevitably means there is more risk in equities than before. As Peter Bernstein reminds us: "Managements are appropriating to themselves responsibility for the reinvestment of an outsize proportion of earnings, rather than giving stockholders the option of deciding whether to reinvest in the same companies that produce the earnings."

For investors, future returns will be very much dependent on capital appreciation - "what someone else will be willing to pay at some point in the future for the assets you own today".

The point, as always, is to be aware of the longer-term risks you are running. At the very least, history suggests one needs to be cautious about the ability of managements always to act in the best interests of shareholders. Yet today's markets are, in effect, betting both that managements are capable of delivering better results for shareholders than ever before and that the markets will continue to recognise the fact in high p/e ratios.