Equities versus bonds: Which asset class offers best value?

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Investment managers of balanced portfolios use a myriad fundamental and technical indicators on which to base their decisions regarding their portfolios’ allocation between equities, bonds property and cash.

And following a 27,3% rally in domestic equity prices since the FTSE/JSE All Share Index hit a low of 18 121 on 3 March this year, the decision regarding whether to overweight or underweight equities has become somewhat more difficult, to say the least.

A method of trying to gauge whether equities are cheap or expensive is to compare their valuations with those of other asset classes. One such technical indicator that managers look at is where equities are trading relative to bonds. To do this, one can compare the earnings yield on equities with the current yield on long-term bonds.

The earnings yield on the FTSE/JSE All Share Index (see Graph A) has declined from 12,4% when the market reached a low on 3 March to the current level of 9,2%. This can be ascribed to the significant rise in share prices since 3 March, and despite the fact that this represents a significant decline, the current earnings yield is still significantly higher that the long-term average of 7,5% since 1989.

To compare the relative value of equities versus bonds, one should look at the difference or spread between the yield on the two asset classes (i.e. the yield on the BESA All Bond Index minus the earnings yield of the All Share Index). With the yield on the All Bond Index currently at 9,5%, the spread stands at 0,3% (i.e. 9,5% – 9,2%). Although the spread has narrowed significantly since the market reached a low on 3 March (see Graph B), when the spread stood at -3,0%, it is still a long way off the long-term average, which stands at 5,1% when measured from the beginning of 1989.

Despite the fact that long-term bond yields have ticked up since their low of 8,9% on 18 December 2008, the yield is still close to its lowest level in more than 20 years (see graph C).

So what can be concluded from this data? Bond yields are almost on par with the earnings yield of equities. However, the earnings yield of equities is still significantly higher than the long-term average, while bond yields are close to a low not seen in more than 20 years. It is hard to come to any conclusion other than that equities are still cheap compared to bonds. And even though the recent equity market rally may prove to be a case of too much too fast and a short-term pull-back may be on the cards, there are signs that the pace of the global economic meltdown is slowing and that some green shoots are appearing. Even at current levels there is good potential for capital growth from equities over the next few years.

I am of the opinion that bonds have already discounted a very gloomy economic picture and more interest rate cuts by the South African Reserve Bank. And then we still have inflation to contend with, which although on a declining trend, remains stubbornly high. I believe there is little chance of significant declines in long-term bond rates and the potential for any capital growth over the next year or two is therefore limited. In fact, with an expected mild improvement in the global economy during the second half of this year, leading to higher commodity prices and an improvement in the domestic economy, we may see long-term bond rates rising and bond prices declining.

Graph A

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Graph B

evb-pic2

Graph C

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