Beware bond-equity rotation and focus on value

January 11, 2013

By Robert Cole

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

Investors have started 2013 feeling bold. Equities are firm, bonds are weak and gold is soft. Is this the long-awaited rotation back to risk? Many market participants say so. But betting on a herd movement is a dangerous investment strategy.

January’s apparent flight from safety may herald the start of a new phase. It could equally be a false dawn. Stock-market recoveries have fizzled out many times before. Moreover, making a wholesale switch from one asset class to another flies against the sound investment principle of investment diversification.

Bulls will argue that the world economy has stabilised and the United States is poised to lead a durable recovery. By the same token, the risk of deflation and depression is receding. Perhaps. But even if the economy is improving, that wouldn’t justify betting the farm on stocks. This century, equities haven’t always followed the same trajectory as GDP. Overvalued stocks can tumble even as economies expand.

It’s true that shares, generally speaking, are cheap. The dividend yield on the FTSE-100, for instance, is 4 percent while the UK 10-year gilt gives just over 2 percent. The picture is similar across developed markets in Europe, the United States and Asia. That is illogical if you assume that dividend income is sustainable. Meanwhile, prospective price-earnings ratios – at around 11-13 times, depending in where you are in the world – are below historic averages. That makes allowance for the known threats to corporate earnings, such as the limited scope for further cost-cutting, increased taxation, or economic shocks.

Conversely, real yields on many top-grade government bonds are negative. Exceptional monetary policy is the usual explanation. Whatever the cause, bonds look expensive relative to stocks.

These valuation anomalies have been around for longer than since the New Year. No data has suddenly emerged to explain a mega rally in stocks or the bursting of the bond bubble. The weight of money behind any rotation will have its own pricing force. But investors shouldn’t assume that a bond sell-off will automatically push money into the stock market: shares may simply tread water.

Rotate if you will. But the investment decision should turn on value.

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