Traditionally, equities have commanded a 5% premium over the bond yield, largely due to bonds remaining the asset class that is routinely ignored, and investors preferring stocks and currencies for reasons yet to enjoy proper justification. Not only has this become entrenched in the psyche of investors everywhere, but significantly, the fundamentalist revolution will tolerate it no more.
As history shows us, other stock markets around the world have suffered a number of catastrophic events, to provide the investor with as much as two opportunities to lose 100% of their investment in the past century. The United States however, remains the exception. It is extraordinary that it has not come to the same grim end as the Japanese or European stock markets, and in that respect ought to be treated discriminately.
Simply, the 5% premium in favor of equities is concomitant to the risk that stocks pose vis a vis bonds. If the risk is not reflective of a 5% premium it cannot be justified. Economic growth is achieved through innovation. If there is no innovation to speak of, there will be no economic growth and neither in this situation can a 5% premium be argued. The premium that equity enjoys over bond yields is dependent on inflation; if inflation is rising, bond prices will be under pressure. Due to the fact that equities are a good hedge against inflation, the premium in this scenario however, may well merit some consideration. The incontrovertible truth however, is that fundamental analysis of the real interest rate achieved is mandatory in the counter-revolution that will emerge.
Currently, inflation is targeted by the Federal Reserve to be 1.8% over the next 10 years. The inflationary component priced into the 5-year bond is 1.8% and that priced into the 10-year bond is 2.1%. In the fullness of time, as the economy builds momentum, the target will appear to be more and more inappropriate. See now, when inflation is at 5% it will still receive the familiar rhetoric of a central bank who will insist that their target is 1.8%, in an effort to coerce the market. On this occasion however, the power of suggestion as fortified by efficient markets theory, will prove ineffective. Regardless, the global economy including Europe will set a course along the path of inflation.
Further, there is ambiguity in the real rate of inflation. Hedonic adjustments have been rife, and while it may assist a Central Bank in the discharging of its duties, the real rate of inflation will be considerably magnified. It is intangible anomalies such as these that efficient markets theory fails to consider, and it is precisely what will be required of sound investments in the coming new environment – fundamental analysis. Again, traditionalists have held the view that stocks will outperform bonds however, in the past 10 years bonds have triumphed, with considerable economic growth resulting despite a return being postponed by equities. Growth stock investors have disregarded the importance of dividends in the past, but now alternatives will be available. The divide between fixed interest markets and equity will be a practice of the past. Comparisons will be made between the yield offered by bonds and the dividend yield on stocks.
