By Michael Baxter 7 Sep 2010 [0 Comments | 713 views]
Related articles
Bond are expensive. Very expensive. The yield on UK, US and German government bonds has fallen through the floor. This means that for investors looking for income, equities are looking decidedly more attractive. For this reason many are predicting a boom in share prices. But for every bull there is a bear. And in the deep cave lurks one of the most bearish of all analysts. Last year, Robert Buckland of Citigroup set the cat amongst the pigeons when he said “the cult of equities is dead2, and predicted sharp falls in equities ahead. Now he has spoken again, and this time it’s a full cattery that has been set loose.
Last year Robert Buckland caused quite a stir when he talked about the end of the cult of equities. See: Is the cult of equities dead?
Now he has been at it again. In a new report he said: “The cult of the equity is dead. Long live the cult of the bond.” He added: “The demise of the equity cult will continue to have profound implications for the global economy and markets. It is likely to keep capex levels subdued. Why bother to build when you can buy existing assets cheaply? Mega caps are likely to trade at discount valuations until they show a more meaningful intention to address their equity oversupply problems, perhaps through buybacks or breakups (or preferably both). They were quick to exploit the rise of the equity cult, but have been slow to respond to its subsequent demise.”
In theory, shares should be priced such that their dividends, plus the rate of inflation, plus an allowance for growth, minus a further allowance for risk, should equal the yield on bonds. For most of the second half of the 20th century, shares were priced such that dividends were lower than the yield on bonds. For much of that period this made sense. For one thing inflation meant that the true yield on bonds over time was often negative. At least dividends went up. Furthermore, for the 25-year period ending in 1973, the global economy enjoyed its best run of growth ever.
Company profits went up with growth, so higher p/e ratios were justified.
But by the 1980s and 1990s growth slowed, inflation began to fall, and yet still equities outperformed bonds. Why was this? Maybe investors were living in the past. Attitudes had been changed by the twin effects of inflation and unusual economic growth, and when those twin effects began to wane, attitudes did not change with them. This is the story of history. Attitudes are moulded by events, but when the events pass, the attitudes remain. This is not always a good thing.
The dotcom crash, when the FTSE 100 reached its all-time high, may have marked the end of this bull run. And bit by bit, investor attitude to risk has changed. The assumption that shares relative to dividends should be more expensive than bonds is changing. Hence Buckland’s claim that the cult of equities is dead.
He said: “Many mega-cap CEOs think that their low PE reflects market concerns about growth prospects. But maybe it is more basic than that. They (or more likely their predecessors) issued too many shares in the late 1990s when their equity valuations were high. They have been reluctant to redeem those shares now that their valuations are low. Consequently, there is an ongoing share overhang, which conventional equity investors just do not have the firepower to absorb. Until mega-cap CEOs recognise this and begin to buy back truly meaningful amounts of their equity (something that most remain reluctant to do), they will likely continue to languish at lowly valuations. For now, many are more inclined to buy their smaller competitors for cash, a strategy that will only further widen the valuation gap between them and the rest of the market.”
During the first half of the last century, dividends were higher than yields on bonds. Maybe we will return to that era. If we do, the implications for pensions will be catastrophic.
The end of the stock market bull run that occurred in 1999/2000 was more significant than is commonly realised. If shares had carried on booming, there would be no impending pension crisis, and no talk of working until we drop (or if you are French, of working until you are the ripe old age of 62). If the cult of equities is really over, then growth in our pension portfolio will follow the trajectory of a snail’s pace.
But is Buckland right?
There are two quite separate issues. Remember the equation: shares should be priced such that their dividends, plus the rate of inflation, plus an allowance for growth, minus a further allowance for risk, should equal the yield on bonds.
Firstly, do you believe we are set to face inflation, or deflation? If inflation is negative, than this should push the price of shares down, and bonds up.
Secondly, it depends on economic growth. If you believe we are in for a period of sluggish growth, then there is no reason to believe corporate profits will carry on rising, and once again, shares should fall.
It’s a very gloomy picture, but there are reasons for optimism. As has been argued here many times before, the combination of technology and globalisation could yet propel the global economy into a new, golden age of growth. It is just possible that, like a certain famous parrot, the cult of equities is not dead at all, merely resting.
