Are bonds too expensive or equities too cheap?
Posted on 18 September 2010 with no comments from readers
Some more conservative investors are in danger of finally joining the long rally in stocks just at the wrong moment because they have convinced themselves that stocks are cheap in relation to bonds, and so are just the thing to buy.
But what if it is bonds that are overpriced and that gives the mistaken impression that equities are cheap when in fact they are overvalued in relation to their true profit outlook and growth prospects for the economy? Ergo it is the bond market that will shortly take a tumble and that means the cost of money will rise, hitting profits for stock market companies and bringing their value down too.
Bond bubble
It is all too easy as to somehow treat bond yields as set by the Federal Reserve and therefore fixed, and yet we know from history that bond prices and yields have fluctuated over wide ranges over time, and are no more fixed now than then. A whiff of inflation is all it takes to spark a bond market sell off and raise yields.
Bond market sell offs do not automatically benefit equities, after all equities will then have to pay higher dividends to keep up with rising yields on bonds. Higher dividends have to come from lower equity prices unless profits rise.
But the main point of this article is to note that ultra-low bond yields can create an illusion that equity yields are some kind of a great buy when quite clearly they are not. The comparative might look good but the wrong conclusion drawn. It is bonds that are too expensive not equities which are cheap.
Bonds too expensive
On what basis can that conclusion be reached? Well, nobody is doubting that yields on bonds have not been this low since the 1930s, so it is pretty self evident really.
Bonds are in a bubble, few would disagree with that. For equities to be cheap you have to think this deflationary environment will persist long-term, surely something that the inflationary Fed will do everything in its power to stop.
Bond prices will fall, interest rates will go up and equities will go down but not by as much as bonds – only in that sense can equities be seen as cheap in the current market.
