Reluctant share rally continues, but the risk of equities remains

The reluctant rally continues. Investors are buying shares in disgust as they hunt for alternatives to super-low - in Europe negative - yields on bonds and cash. This has now become the standard explanation for buying shares at valuations not seen since the dotcom bubble: the money has to go somewhere, and everything else looks worse.

Wall Street for decades has compared bonds and equities using the Fed Model, or variants. Named for a Federal Reserve chart from the late 1990s, the model compares the bond yield to the equity earnings yield, forecast profits as a percentage of the share price.

The original idea was that the two should be equal. If the earnings yield (which is the inverse of the price/earnings ratio) is higher, shares are cheap, while if the bond yield is higher, shares are expensive.

Redrawn for the post-crisis age, it has worked wonderfully over the past five years, as the chart below shows. The bigger the yield gap, the stronger the buy signal, and the higher equity returns were over the subsequent two years.

There are a few problems. First, the theory is twaddle: the bond yield is nominal, and there is no reason it should match the earnings yield, which can be expected to move with inflation.

Second, the model has a terrible history. In April 2008 it gave the strongest buy signal for shares since the early 1980s, six months before the biggest crash since 1929. It did not work before the 1980s, and did not work in most markets outside the US. Like the chart below, it is a product of data mining.

Worse, even if the pattern since 2010 continues, it suggests poor returns from here: about 5 per cent a year, before inflation. That may look appealing against a bond yield below 2 per cent, but leaves a far smaller margin of safety than investors usually demand to hold risky shares.

There is an element of truth in the bond-equity comparison. It has probably been strengthened by companies borrowing to buy back shares, too: the lower bond yields are relative to profits, the bigger the incentive to gear up. In principle this can continue for a long time. But it cannot continue indefinitely, and when it ends shareholders will rediscover the risk of equity, and of corporate leverage.

© The Financial Times Limited 2015. All rights reserved.
FT and Financial Times are trademarks of the Financial Times Ltd.
Not to be redistributed, copied or modified in any way.
Euro2day.gr is solely responsible for providing this translation and the Financial Times Limited does not accept any liability for the accuracy or quality of the translation