The UK equity market (FTSE All-Share Index) was up 1 per cent in 2015, but this was enormously held back by the carnage in the resources sector. 
Oil and gas stocks (which accounted for 10 per cent of the FTSE All-Share Index last year) fell by 16 per cent and the mining sector (which made up another 3 per cent of the market) was even worse, falling 46 per cent.
If we could strip out these two sectors then the All-Share would have been up nearly 6 per cent last year.
Performance of indices in 2015
Source: FE Analytics
This isn't just a case of 'coulda, shoulda…didn't'. It presents a real conundrum for investors, especially those orientated towards income. And this is why.
The resources areas of the market make up nearly a quarter of the forecast income of the stock market for 2016. The oil majors such as BP and Royal Dutch Shell, though reeling from the 70 per cent fall in the oil price from $110 in the summer of 2014 to below $30 now, remain very committed to paying their dividends.
Rio Tinto and BHP Billiton, the largest quoted Mining companies, are saying a similar thing.
They all plan to cut costs. They are putting a line through new projects and expansions and they are cancelling exploration budgets. They all know 2016 will be a terrible year for profits, but they point to their strong balance sheets and, so far, are saying that this will enable them to pay uncovered dividends, if needs be.
On one level, this is incredibly compelling.
At 11th January prices of 1355p, Royal Dutch's forecast dividend of 129p offers a dividend of 9.5 per cent. This is absolutely huge on both an absolute and relative basis.
However, this dividend is barely covered by forecast profits. In fact it amounts to paying-out 95 per cent of next year’s earnings. BP is similar: a dividend yield of 8.4 per cent, but this is 105 per cent of forecast earnings.
Rio Tinto yields 9.4 per cent, but again, that is based on them paying out more than all of their profits. BHP Billiton offers a 13.4 per cent yield, but that’s nearly three times its forecast profits.
But beware: such high yield is “danger money”.
These yields are high because the market 'knows' that they are unsustainable. And without a massive rally in commodity prices, unsustainable is exactly what they are.
The risk is that as 2016 unfolds, the major resource companies move from a 'progressive dividend policy', where they seek to nudge the dividend along year-in, year-out to a policy more clearly based on a pay-out ratio. This would probably be sensible.
A progressive dividend policy in a cyclical industry is always eventually going to run into trouble. But moving to a pay-out ratio-based policy, where the companies pay out, say, one-third of earnings, maybe with a teaser of special dividends if balance sheets are strong, would see some pretty ferocious dividend cuts.
On this basis, BHP Billiton would yield 1.5 per cent not 13.4 per cent!
Performance of stocks versus index over 3yrs
Source: FE Analytics
I think we can draw three conclusions from what is likely to unfold.
Firstly, if you are seeking income, don't be too greedy. High absolute yields on their own are often a warning sign rather than an invitation. Whilst some of the Resources stocks will deliver on their dividend pledges, in the medium-term this is utterly reliant upon a rally in commodity prices.
Hope is not a strategy. There are much safer hunting grounds for the income-orientated investor in other areas, such as pharmaceuticals, telecoms and even financials.
Secondly, those who have said equities look great value on a yield basis, may have some unpleasant surprises.
The UK equity market offers a dividend yield of 3.7 per cent, which sounds great, but if nearly a quarter of that income is at risk, we need to look beyond the headline number.
On my calculations, if all the resource stocks moved to a one-third pay-out ratio then the yield on the UK equity market is nearer 3.2 per cent. Still not bad perhaps, and of course still a big premium to bank deposit rates and to 10-year gilts, but plainly less attractive than it first appears.
Finally, the actions of the major resource companies, cutting growth plans so they can pay big dividends, is exactly the sort of behaviour that exacerbates the cycle. As and when the upturn comes, a shortage of supply will squeeze prices upwards.
This is definitely not a problem for now, but the seeds are being sown.
Eric Moore is co-manager of the Miton Income fund. All the views expressed above are his own and shouldn’t be taken as investment advice.
