The 'yield gap' is an idea that has a long and happy history of predicting when stock markets are undervalued. But the rules of the game have changed, says Bengt Saelensminde. Here, he explains why.
"I am betting on the stock market rising substantially." That's from a Telegraph article I've just read. Read it here. According to James Bartholomew, a reliable old City indicator is suddenly signalling that stocks are now grossly undervalued. And in fact they could be about to double.
Sounds crazy, doesn't it? That's because it is. Mr Bartholomew has made a fatal error. He doesn't realise that the rules of the game have changed. That we are entering a new era for investing - a deflationary environment where everything that we know is turned on its head.
Trouble is that a lot of people will be taken by this kind of dangerous talk. And they could lose a lot of money in the process.
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Today I want to talk about this old indicator - the 'yield gap'. This is an idea that has a long and happy history of predicting when markets are undervalued. But the rules of the game have changed. And you need to act now to protect your wealth.
Don't trust out-dated market concepts
The yield gap is the difference between the yield on government bonds and equity dividends.
The idea is that bonds should pay out more interest than shares because bond coupons (the interest they pay) don't keep up with inflation. Equity dividends, on the other hand, go up over the years as the economy grows and inflation helps to increase company profits and dividend payouts.
In the past, the yield gap has been used as a signal that markets are over- or under-valued. The narrower the yield gap, the bigger the buy signal for stocks.
But using this 'rule' at the moment is downright dangerous. As the article in the Telegraph notes, right now the yield gap implies that equities are set to 'rise substantially'. They tell us that equities could double to bring the yield gap back to where it 'ought' to be.
So are equities set to double? Well, of course, they 'could', but I reckon there's a fatal flaw in this argument.
Why we are entering a new era for investing
If you go back in history, you'll see that bonds didn't always yield more than equities. Why? Because we didn't always have inflation.
In the UK, inflation is largely a modern phenomenon. And it only really got going when we came off the gold standard in the early 1930's. By 1971 the whole globe had given up on gold and inflation became part-and-parcel of modern day life.
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And now most investors have forgotten all about life before inflation.
But, here's the thing. Now, for the first time in decades,possibly centuries, we could be giving up on inflation.
And if there's no inflation, then equity dividends may not be growing at all. And if dividends aren't growing, then why on earth should equities be more desirable than bonds?
I'll answer that.
They aren't. And with deflation, the yield gap goes into reverse! If we get deflation, suddenly bond yields could go lower than equity yields. The fixed coupons from bonds become more valuable year by year.
Now, before I get inundated with emails telling me we're not suffering deflation, let me just add something.
The inflation you see today isn't sustainable. The risk is that we are heading for deflation (and you can read more about why I think so here). And that's what the yield gap is trying to tell us.
You have to act now
The stock market doesn't hand out any prizes for investors that can state the bleeding obvious. And here's the bleeding obvious: in an inflationary environment, a 3.5% dividend yield (that's what the FTSE 100 pays) looks pretty impressive versus the 3.9% on the government bond that Bartholomew refers to. All you're giving up is 0.4% interest for getting an inflation-busting dividend.
So much for the bleeding obvious. But stock market prizes go to investors that guess what's going to happen. And right now the clever money is betting on deflation. And deflation makes bonds an absolute steal.
Deflation will make equity investors weep as the yield gap closes to zero. Then they'll positively break-down as the yield gap goes into reverse.
This can happen in one of two ways. Either bonds continue to go up in value (driving the yields down), or equities fall in value (driving their yields up). Either way, bonds are the best bet if deflation bites.
But what if I'm wrong?
If you think that inflation will persist and that companies can continue to push up prices, make more profits and increase dividends, then you should buy equities. The yield gap says you're onto a winner.
And because I want to keep my portfolio diversified, I'm holding onto some high-yield stocks too. I'll never put 100% of my portfolio on anything, even if I reckon I'm right. But I can tell you, there's no way I'm selling bonds right now.
Most of my fellow 'deflationists' agree that this ultimately ends in inflation. But before then, deflation stalks the economy, robbing wealth as it goes.
Remember: deflation is a game changer. Investing ideas like the yield gap must change. You have to have the discipline to change your mind. Make sure you don't leave it too late.
On Monday, I'm going to show you another reason why I don't think equity dividends will merrily go on increasing over the coming years. And that's regardless of what happens to inflation.
I want to show you how some of our largest companies are rotting from the inside. A disease that will only get worse over the next twenty years or so.
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Managing Editor: Theo Casey. The Right Side is issued by MoneyWeek Ltd. MoneyWeek Ltd is authorised and regulated by the Financial Services Authority. FSA No 509798.https://www.fsa.gov.uk/register/home.do
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Bengt graduated from Reading University in 1994 and followed up with a master's degree in business economics.
He started stock market investing at the age of 13, and this eventually led to a job in the City of London in 1995. He started on a bond desk at Cantor Fitzgerald and ended up running a desk at stockbroker's Cazenove.
Bengt left the City in 2000 to start up his own import and beauty products business which he still runs today.
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