It’s 50 years since shares looked this cheap

September 8, 2010

— The author is a Reuters Breakingviews columnist. The opinions expressed are his own —

Successful long-term investors buy good assets when nobody wants them, and sell when the risk-averse are piling in. Bonds are considered “safe havens” today, after shares’ lost decade. That could be about to reverse; the great bull market in government bonds is probably over.

Since 1982, when runaway inflation was going to destroy capital, if not capitalism itself, bond investors who took the risk that the beast would be tamed have been hugely rewarded. But the opportunity to buy 10-year U.S. Treasuries on a 14 percent yield followed a bear market that had wiped out the value of fixed-interest securities.

Companies had shown more resilience to rising inflation, so around 1960 in the United States, UK, Germany and Japan, the “yield gap” between government bonds and shares was reversed. For the next half-century, the dividend yield on shares was below that on government bonds. Until now.

In the UK, Germany and Japan, shares now yield more than government debt. In the United States, the gap has shrunk to around 0.3 percent. This, says Citigroup <C.N>, marks the end of the cult of the equity — extinguished by two 50 percent bear markets (after the dotcom mania and then the credit bubble), a glut of equity issuance and the flight of pension funds from shares to bonds.

Yet the funds are buying bonds because they (or their advisers) deem them low-risk, not because they believe them to be cheap. Today’s bond prices signal that inflation will not return for at least a decade, despite sustained and determined efforts from the world’s central banks to stimulate it.

The risk that central banks will succeed is not priced in, while the risk that they won’t, and that economies stagnate (or worse), is priced into shares. Yet companies have rebuilt their balance sheets after the crisis, and despite sluggish top-line growth, dividends — that unsung, vital part of long-term performance – look sustainable.

Many companies are even raising their payouts. The UK FTSE 100 embraces a fair cross-section of world shares. Evolution Securities estimates its forward yield at 3.8 percent, while 10-year UK gilts return 3.0 percent. Such inversions are extremely rare — as rare as the best opportunities to buy good assets cheaply.

— Citigroup calculates that German equities trade on a 2.9 percent dividend yield, while bunds are on 2.1 percent, and that Japanese equities return 2.0 percent, against 1.0 percent on JGBs.

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And so rose the ETF Index fund takeover of the investing world…

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