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August 18, 2010
Global Equity Strategy
The Rock, Part II – Don’tIgnore Yield
In late 2008, we first wrote about a landmark event –the dividend yield on the S&P 500 exceeding the10-year Treasury yield
(
see: US Portfolio Strategy: The Rock: Yield Support – Nov 08 
). The current spreadbetween dividend yield and bond yield is once againdriving us to re-examine this relationship. Most valuationmeasures (even earnings based) are reasonablysupportive for the US equity market. However, thedividend yield may actually be one of the mostcompelling (despite not being particularly high inabsolute terms at 2.1%).
In itself, the dividend yield rising above (or close to)the long-dated government paper yield can easilybe interpreted as a very bearish development.
It hasbeen a rare occurrence over the past 100 years, tendingto occur only during bear markets. It was a persistentfeature of the 1930s, during World War II, and againduring the 2008/09 bear market phase. Recent yieldshifts are once again forcing us to consider whether theyrepresent a structural break in valuations — i.e., apermanent de-rating.It is easy to get bearish on long-term valuations. For perspective, we consider the relationship between thedividend yield and
real 
rather than nominal rates (sinceearnings and dividend yields are real variables). On thisbasis, it is unclear that valuations are unusually cheap. If inflation continues to fall and real bond yields to rise, thedividend yield gap eventually closes. Only if the dividendyield keeps rising above the rise in real bond yieldswould we worry about a permanent shift in valuations.Longer term this could still happen.
Dividend yield provides downside support.
Whilecyclical growth and earnings risks remain, we think yieldsupport beyond the risk-free rate joins a growing list of valuation measures that help limit downside risk toequities.
Top Dividend Yield Ideas
PriceDYMS Rating
MOAltria Group Inc.22.96.9%E / ITAT&T Inc.27.06.4%O / ALOLorillard Inc.75.96.1%O / IPNWPinnacle West Capital Corp.40.35.4%O / IPMPhilip Morris International Inc.52.65.0%O / IBMYBristol-Myers Squibb Co.26.64.8%O / IMCHPMicrochip Technology Inc.29.14.8%E / CPFEPfizer Inc.16.34.7%O / IMRKMerck & Co Inc35.54.5%E / IETREntergy Corp.79.24.3%O / ICMSCMS Energy Corp.17.34.3%O / IKFTKraft Foods Inc.29.34.1%O / CDDE.I. DuPont de Nemours & Co.41.44.1%E / ICOPConocoPhillips55.94.1%E / AHNZH.J. Heinz Co.46.54.0%O / CGPCGenuine Parts Co.43.14.0%N / NCAGConAgra Foods Inc.21.83.9%E / CCVXChevron Corp.77.83.8%O / AABTAbbott Laboratories50.73.7%O / AJNJJohnson & Johnson59.23.7%E / A
 
17.516.818.014.511.911.08.97.725.30510152025301-1.5% 1.5-2% 2-2.5% 2.5-3% 3-3.5% 3.5-4% 4-4.5% 4.5-5% >5%
   M  e   d   i  a  n   S   &   P   5   0   0   L   T   M    P   /   E
S&P 500's Median Trailing P/E vs. Dividend YieldJan '73 to Mar '10
Current1998-2000period1978-82period
 
Source: Factset, Morgan Stanley Research N = Not covered
Morgan Stanley does and seeks to do business withcompanies covered in Morgan Stanley Research. Asa result, investors should be aware that the firm mayhave a conflict of interest that could affect theobjectivity of Morgan Stanley Research. Investorsshould consider Morgan Stanley Research as only asingle factor in making their investment decision.
For analyst certification and other importantdisclosures, refer to the Disclosure Section,located at the end of this report.
+= Analysts employed by non-U.S. affiliates are not registered with FINRA, may not beassociated persons of the member and may not be subject to NASD/NYSE restrictions oncommunications with a subject company, public appearances and trading securities held by aresearch analyst account.
MORGAN STANLEY RESEARCHNORTH AMERICA
Morgan Stanley & Co. Incorporated
Jason Todd, CFA
Jason.E.Todd@morganstanley.com+1 (1)212 761 7991Morgan Stanley Australia Limited+
Gerard Minack
Gerard.Minack@morganstanley.com+61 2 9770 1529Morgan Stanley & Co. Incorporated
Phillip Neuhart
Morgan Stanley & Co. Incorporated
Naseh Kausar
 
 
2
MORGAN STANLEY RESEARCHAugust 18, 2010Global Equity Strategy
Long bear markets often have strong and violent cyclical rallies.When valuation measures become supportive, these ralliescan be caused by the slightest catalyst (such as a fall in riskpremium resulting from strong policy action, improvedeconomic data from depressed levels, company-specificdevelopments – M&A, positive earnings surprise, or unexpected positive guidance, etc.).
Exhibit 1
Dividend Yield Support Rising Again
10-yr Treasury Yield less S&P 500 Dividend Yield
Jan-09-0.89Aug-100.59Dec-742.18-20246810197019751980198519901995200020052010
 
Source: FactSet, Haver, Morgan Stanley Research
It is hard to know what precise catalyst will trigger a rally fromvery oversold levels. The appearance of dividend yield supportbeyond the risk-free rate suggests that earnings risks arealready heavily discounted and is positive from a verynear-term standpoint.
Exhibit 2
Dividend growth to follow earnings growth
-3.8%46.8%-40%-30%-20%-10%0%10%20%30%40%50%60%1956 1962 1968 1974 1980 1986 1992 1998 2004 2010EPS Growth%YoYDPS Growth%YoY
Earnings and Dividend Per Share Growth (%YoY)
 
Source: Factset, Haver, Morgan Stanley Research
The problem with dividend yield metrics, as withearnings-based valuations, is their reliability. While dividendyield remains some way off the 2009 low (Exhibit 1), on arelative basis there are two striking differences that make itsomewhat disconcerting to find ourselves making thesecomparisons again:1) The degree of earnings risk is substantially lower nowrelative to expectations compared with early 2009. Year-endconsensus estimates at Jan-09 stood at $75, nearly 40%above where they finished the year. For that relationship tohold true today, 2011 earnings estimates would have to fall to$62 from their current level of $95.2) The forward dividend curve was downward sloping for muchof 2009 as earnings estimates were slashed and financialdividends cut. It is now upward sloping, although still somewhatpessimistic relative to what we would consider conservativeestimates. For example, the forward curve assumes DPSgrowth of only 5% in 2011 versus 14% EPS growth (accordingto consensus). This would equate to a decline in the payoutratio from 27% down to 25%. We think the payout ratio is morelikely to rise than fall from current levels.
Exhibit 3
Swaps market pricing in conservative DPS profile
18.117.516.716.817.217.626.725.925.224.523.822.715.017.019.021.023.025.027.02010 2011 2012 2013 2014 2015CurrentJan-09
SPX DPS Expectations: Swaps Markets
 
Source: Bloomberg, Morgan Stanley Research
Rising Dividend Yield Gap – a Structural De-Rating?
Longer term we believe the rise in the spread between dividendyield and real bond yields may represent a statement about themarket’s view on three things:1) An outlook for weak long-term earnings growth that leaves areduced possibility of P/E expansion, meaning that dividendshave to be a dominant part of total returns. As Exhibit 4 shows,the higher the dividend yield, the lower the multiple. Historicallya dividend yield of 2% would equate to a P/E multiple of nearly17x (or alternatively a dividend yield near 3% supports thecurrent market P/E of 14.5x). We do not think a 3% dividendyield is unrealistic. It would require the payout ratio to rise intothe low 40% range – a move that would put it back close to thelong-term average. 
 
 
3
MORGAN STANLEY RESEARCHAugust 18, 2010Global Equity Strategy
2) A higher risk premium (we estimate the implied ERP is nowaround 5.2% - Exhibit 5) that now needs to be compensated bya higher yield.3) Investors doubt that companies can be trusted to reinvestearnings and create value. Companies are better off enhancing the payout ratio and returning money to investors,something we have yet to see in the current cycle.
Exhibit 4
Higher Dividend Yields = Lower Multiple
17.516.818.014.511.911.08.97.725.30510152025301-1.5% 1.5-2% 2-2.5% 2.5-3% 3-3.5% 3.5-4% 4-4.5% 4.5-5% >5%
   M  e   d   i  a  n   S   &   P   5   0   0   L   T   M    P   /   E
S&P 500's Median Trailing P/E vs. Dividend YieldJan '73 to Mar '10
Current1998-2000period1978-82period
 
Source: Haver, Thomson Financial, Morgan Stanley Research
Exhibit 5
Implied ERP close to ex LEH highs
S&P 500 Implied Equity Risk Premium (%)Based on ROE-Revert-to-Mean
5.2%1%2%3%4%5%6%7%8%19901992199419961998200020022004200620082010
 
Source: QDS, Morgan Stanley Research
These concerns are perfectly logical, as a low payout ratiosignals two dangers. First, companies themselves may believeearnings growth is unsustainable and so do not raise dividendsin line with earnings. Eventually earnings growth normalizesand the payout ratio rises, as earnings growth falls anddividends are either maintained or fall at a slower pace.Second, if earnings growth significantly exceeds sustainablelevels, management may become complacent and instead of returning money to shareholders start to over-invest anddestroy capital. Inevitably, earnings growth falls. This was thecase with Tech in the late 1990s and Financials more recently,where managements for banks and broker dealers arguablydid not focus on sustainable earnings based on sustainableleverage.Even now with earnings normalizing from excessively highlevels, the S&P 500 payout ratio at sub-40% is still low, and wewould expect the ratio to continue to climb into the nextearnings recovery, potentially stabilizing closer to 50%.We have run some screens to highlight stocks that lookattractive on a yield basis. We apply some basic filters to raiseconviction levels in the sustainability of current dividends.1. We create a buffer by only considering stocks withyields more than 1% above the Treasury yield (acutoff of around 3.7%). See Exhibit 10.2. We substantially lower earnings estimates for 2011,which have only just started to be downgraded. Wecut consensus estimates by 20% for cyclicalcompanies in Discretionary and Materials, 10% for Industrials, Energy and Technology, 20% for Financials, 5% for non-cyclicals (Telecoms, Utilities,Healthcare, Staples). We then assess how manycompanies’ dividend payout ratios are still below 60%.See Exhibit 8 for a list of these stocks. Our top pickshere are CVX, COP, PFE, ABT, MRK, CAG, JNJ,NEE, PEG and NU.3. We try to eliminate the risk of future earnings andexamine dividend sanctity by looking at how manytimes the 2011 dividend is covered by cash andmarketable securities less short-term debt on thebalance sheet. See Exhibit 9 for a list of these stocks.Our top picks here are LTD, LO, CVX, GPC, PFE, JNJ,MCHP, CAG, BMY and MRK.Besides the stocks mentioned above, we also have strongconviction in T, PNW, PM, ETR, CMS, KFT and HNZ on a yieldbasis.
The Importance of Yield in a Changing Total Return Profile
The risk-adjusted returns between bonds and equities shouldbe equal in the long run, although major dislocations in relativereturns can easily persist for substantial periods of time.In a steady state:Nominal Bond Yields + Risk Premium = Return from Stocksor 
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