The Yield Indicator

With government bonds yielding less than equities, is a buy signal approaching for stock markets?

James Mackintosh, investment editor at the Financial Times, points out that government bond yields have moved below broad equity index dividend yields in several countries: Japan, many European countries, the UK and now even the US (if you use the Dow Jones Industrial Average as your benchmark). Isn’t this a buy signal for shares?

As Dian Chu of Economic Forecasts and Opinions put it last week, “Equities historically outperform bonds. And the current Dow 30 composition is probably the strongest on record. So, the strategy here is simple–get in on these blue chips when everyone else is still playing musical chairs over at the bond market. Then, sit tight knowing at least a portion of your portfolio will ride the Dow 30’s nice dividend yield, and the price appreciation coming from their solid long term top line growth.”

Here, from the FT’s helpful video on the subject, is the chart of US equity and government bond yields in the year to date. The decline in bond yields has been dramatic, while the Dow’s dividend yield has drifted slowly upwards. Incidentally, the yield crossover has yet to occur for the broader S&P 500, and it hasn’t occurred – yet – if you use the 30-year, rather than 10-year bond yield.

However, as Mackintosh points out, the yield indicator doesn’t always work. In Japan, for example, when the equity dividend yield moved above Japanese government bond yields in late 1998 and early 2003, it was indeed a signal to switch from bonds to equities, and on both occasions equity investors more than doubled their money in the subsequent year or two. However, the most recent crossover, from 2008 onwards, has simply failed to work. Equities languish at 20-year lows, while bond yields have carried on down.  See the chart below.

As we argued a couple of weeks ago (“Equities for Income?”), yield relationships between bonds and equities looked a whole lot different before the 1950s.

The “Fed model” of the interrelationship of bond yields and equity earnings yields, popularised in the 1990s by many Wall Street strategists and used to justify higher stock weightings when bond yields fall, has now completely broken down, for example.

A completely different model, explained by strategist Bob Bronson, posits a relationship between the bond and stock markets that switches polarity, depending on where we are in what he calls “supercycle economic seasons” – a concept similar to Kondratieff or long-wave cycles.

In the supercycle autumn, which prevailed for most of the 80s and 90s, according to Bronson, bond and equity yields could indeed move in the same direction. Now, he says, in the winter phase, bond yields are falling while equity yields move up – a complete reversal of the relationship of the previous two decades. Plus, he adds, there will be a generalised increase in risk aversion and a decline in P/E ratios, neither of which is bullish for equities.

So don’t place too much store in recent historical relationships from the asset markets – it can pay to cast your eye further back in time. And, if you are playing a possible equity recovery via ETFs, make sure you’re receiving the full dividend stream, or as much of it as possible. As we pointed out recently (“Those Leaky Dividends”), it’s easy to forfeit up to a third of your income from shares without really being aware of it.

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