Stocks aren't cheap – bonds are expensive

The FTSE 100 has practically gone nowhere over the last 10 years or so. Some pundits reckon that has left stocks looking cheap, particularly compared to bonds. But they're wrong, says Tim Bennett. Here's why.

Index trackers are tempting for lazy investors they are low cost and simple to understand. But if, like me, you have dripped cash into a FTSE tracker over the last five years, you may wonder why you bothered.

Five years ago, the index was above 6,000 points, but now it's slightly below. Over a ten-year period, as Barclays notes, a real (after inflation) return of 1.2% per year is still pretty poor (and a real loss in 2011 of almost 8% was dire).

Over 20 and 112 years things look better the FTSE 100 real returns are 4.8% and 4.9% per year. But to expect returns to revert to these figures, you'd have to believe equities are cheap. And you'd be mistaken, say Barclays.

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Who cares what Barclays thinks?

Investors are barraged with influential-sounding reports. So what's special about the Barclays Equity Gilt study? Firstly, it is extremely thorough. Over 120 pages, the report studies annual returns from asset classes, including shares, government bonds, corporate bonds and cash from 1899 to 2011. Secondly, published every year since 1956, it has a long track record and carries a lot of clout. And the news from the latest edition for anyone in, say, a FTSE 100 index tracker isn't good.

The big flashing buy signal

One of the key arguments used by equity bulls runs like this; the expected premium you can earn in return for the extra risk of holding equities instead of risk-free gilts (the "equity risk premium") is too good to ignore. As the Barclays study puts it, "equity risk premia are meaningfully higher than historical experience". In plain English stocks offer a better return relative to risk than gilts. Plainer still stocks are cheap.

Between 1950 and 2011, equities offered a real return annually of 4.48% from dividends and 1.66% from capital gains for a total of 6.15% (note how important dividends are to your total returns). The equivalent return from a risk-free asset (a medium-dated gilt) was 1.94%, so the extra you earned from shares was 4.21% (6.15%-1.94%). Over 1900 to 2011, the equivalent "equity risk premium" drops to 3%. So where is it today?

According to Barclays, UK equities are currently "priced to yield long-term inflation-adjusted returns" of 6.26%. For this to revert to anything like the long run 4.21%, let alone the 3% above, bulls say share prices must rise sharply and bring the equity yield down.

But is the expected return from equities really so high? No, says Barclays. The real reason for the risk premium gap of 6.26% is not that equities are a bargain but gilt yields are incredibly low and likely to stay that way. The equity risk premium hides a massive bull trap. As the report puts it, "despite unusually high equity risk premia, current valuations are not especially cheap".


Gilt yields have gone so low a ten-year gilt offers just over 2%, a 300-year low that inflation-adjusted yields (the yield minus the inflation rate) are negative in Britain, America and Germany.

This "striking collapse in government bond yields over the past decade, particularly since 2008, marks a rupture with post-war financial history", notes the study.

The factors that would normally push yields so low are not obvious now. Although there's been a flight to safety (which pushed gilt prices up as investors bought them, and sent yields down) since the financial crisis, "the fear that would in the past have been required to push yields so low is just not evident". So why is the market still pricing in "an extremely long period of very low real rates"?

The shortage of safe havens

Safe-haven government bonds have "become extremely scarce relative to the demand for them". This trend was evident well before the crisis and was accelerated by it. As a percentage of global GDP, safe assets (including US government debt and the public debt of large European governments) shrunk from 36.9% in 2007 to 18.1% in 2011. But even before 2007 the pool was shrinking at a good 5% per year.

In the pre-crisis boom years, demand for AAA-rated safe-haven assets was muted, so governments didn't create as many. Since the credit crisis, huge swathes of US mortgage-backed securities and Italian and Spanish government debt have vanished as they've been downgraded. Quantitative easing has removed lots of the remaining ones, as the British and American governments bought them in an attempt to push money into riskier assets.

So in Britain, as elsewhere, says Andrew Clare, professor at Cass Business School, pent-up demand for gilts from pension funds and other investors will be fighting government reluctance to issue them for years to come. That means high prices for gilts, low yields and a large gap between the expected return on bonds and shares are here to stay.

What to do

That gap is creating an illusion that shares are relatively cheap, says Barclays. They are not instead, scarce government bonds are horribly expensive and likely to stay that way. So forget FTSE 100 trackers as a way to make decent money they are likely to carry on drifting. Be stock-selective instead.

This article was originally published in MoneyWeek magazine issue number 577 on 24 February 2012, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.