Mind the gap: equities are not yet cheap

The difference between bond yields and equity yields - the 'yield gap' - is closing. And according to the bulls, that means it's time to buy stocks. But it's not that simple, says Merryn Somerset Webb.

Are equities cheap? If you believe in the 'yield gap', the answer is yes. The theory around this holds that, in a normal situation, equities should yield less than bonds and when this situation either reverses or comes close to doing so, it represents a massive opportunity (for those with the guts to take it) to buy into the equity market.

Why? Because the amount paid out on bonds the 'coupon' doesn't rise over the term of the bond. That means that it doesn't compensate for inflation and that investors need a high yield to do the job instead. Equities are better at compensating for inflation dividends should rise as prices rise and the real assets represented by many equities at least hold their value when prices let rip.

I know this sounds rather dull, but the yield gap (the difference between the yields on bonds and equities) is nonetheless causing great excitement in the financial services world this month because it is closing.

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So much so, that in the UK, Germany and Japan, you now get a better yield on shares than you do on bonds. The same is close to being true in the US.

According to the bulls, that makes it time to buy, buy, buy. For the gap to return to 'normal' levels, it will take a huge and dramatic rise in the value of the stock market.

However, while this all sounds very attractive, there are problems.

First, whether this makes any sense at all depends on what kind of 'normal' we are living in. Inflation wasn't something people consistently expected until relatively recently. Pre-war, we lived in an era of much more stable prices. Back then, equities always yielded more than bonds. Without inflation to worry about, investors were prepared to take a lower yield from bonds because buying them involved less risk than buying equities. So, if we are now moving to a new kind of normal, one in which deflation is more of a risk than inflation, we should actually be expecting equities to yield much more than bonds.

Look at it like that, and there should be not a dramatic rise but a dramatic fall in the stock market. That wouldn't be so good.

Second, there is an even simpler problem with the yield gap: as an indicator, it doesn't appear to work very well, anyway. A note out this week from Lombard Odier points out that there is in fact "no correlation between the dividend yield gap and forward real equity returns".

So "buying equities when the dividend yield gap is positive (i.e. equities yield more than bonds) is not a systematically more profitable strategy" than doing the opposite. So much for that.

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Still, the yield gap isn't the only thing telling the bulls that equities are cheap. Analysts are now also claiming that forward price/earnings (p/e) ratios are telling us the same. The S&P 500 index is currently on a forward p/e of 12.6 times when its postwar average is just over 13 times.

But there are problems with this, too.

First, the fact that the ratio is a tad below its average hardly tells us it is particularly cheap.

Second, the fact that the ratio being used here is a 'forward' ratio makes the comparison silly. As Lombard Odier point out, times are tricky and no one has any idea what corporate earnings will come in at next year and therefore no idea what p/e ratios will be.

Mostly, when analysts say "forward", what they mean is "made up by extrapolating last year's numbers out a bit". That is particularly dangerous at the moment given that we are on the edge of a dangerous double dip and that, thanks to the cost- cutting forced by recession, profits are currently abnormally high.

All this should make us nervous as should the fact that the only reliable indicator of market performance, the cyclically adjusted p/e ratio (CAPE), is telling us the market is not remotely cheap. According to Lombard Odier (which is clearly staffed by very bearish people), it is currently knocking around 23 times, which is significantly above its long-term average.

So there we have it: on the measures that work, equities aren't very cheap at all. That doesn't mean you should be completely out of the market. Everyone might now think we are entering a deflationary phase, but the risks that we'll get fast inflation instead remain very high indeed. If that happens, the question of whether equities are cheap will be by the by. Everyone will just pile in for the sake of the protection.

With that in mind, I'd still be hanging on to the high-yielding dividend-growing stocks I mentioned last week, and I might also be looking at the City of London Investment Trust (LSE: CTY). It has a 44-year record of producing a rising dividend and a current yield of 4.7% both of which make it just the thing for those who are after inflation protection.

This article was first published in the Financial Times.

Merryn Somerset Webb

Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast -  but still writes for Moneyweek monthly. 

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.