The Reality of Relativity

Equities still look attractively valued compared to other assets

9th March 2009 might not be a memorable date for the vast majority of the population, but for many of those who work in financial markets it’s a date they will always look back on. It marked the low in the S&P500 after it had more than halved during the financial crisis.

Global equity markets have performed very well since that low point. Even the underperforming sectors have clocked up total returns of over 80% (in US Dollar terms) over the period while the top performing sectors of the market have delivered returns per year averaging just over 25%, amounting to a total return of over 300% over six years. It’s an astonishing outcome. At the start of the six year period there were analysts who were worried that the world’s financial system could collapse and that economic growth might be permanently damaged by what had taken place. They thought that the most attractive asset was cash. We know that times like this provide the best investment opportunities. Hundreds of books and papers have been written on the subject of buying distressed and unloved assets. It’s still hard to do, of course, as it feels horrible to buy assets that everyone else hates. But it works as an investment approach.

Having risen in value by so much, we now have to ask ourselves what might happen next. Are equity markets still attractive? If so, what should we invest in? Are any of the other asset classes more attractive?

These decisions cannot be made in a vacuum or just by looking at price itself. We need a way of assessing where markets are compared to underlying fundamentals and what the likely future investment returns might be. There are many ways of doing this. Three obvious ways are 1. look at the real yields that prevail today, 2. compare those yields to where they have been in the past (or where we expect them to be in a neutral or equilibrium world) and finally 3. look for evidence of behavioural biases within markets today.

Taking the first of these, it would seem that real yields today do look rather odd in some cases. Cash and Western government bonds are currently offering very low yields and most are negative in real terms, while global equities are mostly in the range of 5.5 – 7% real, with a handful yielding more than that and a few in double digits. It’s hard not to conclude that something rather peculiar is taking place. Why would investors pay to lend money to western governments? The only rational explanation is that they crave the certainty of a negative yield rather than the uncertainty that comes from buying risky (or volatile) assets. Plenty has been written on negative bond yields including some excellent analysis by our colleagues at In comparison to this rather strangely priced set of fixed income assets, many equities appear to be offering reasonable real returns, as implied by their prevailing yield. The gap between the yield on equities and that on either bonds or cash (the equity risk premium) looks very high. On the face of it this gap suggests that equities are likely to beat bonds in the period ahead. How might this gap close? One way that this gap narrow is by equities re-rating (i.e. yields falling). There are other possibilities though – bond yields could rise, or earnings could fall. Or the gap could close through a combination of these effects. So a high equity risk premium is not unambiguously good news for equities.

Comparing today’s real yields on equities to the history of those yields is a straight forward exercise. For most markets and sectors, yields are lower today than they have been for the last 10 years. And one or two (including the US) are lower than the levels that we have in the past expected them to average over multi year periods. They are lower than the neutral or equilibrium yield. Should we take fright at this? Does it mean they have re-rated too far? On the face of it the answer might be “yes” but then we do need to ask what is so special about the average of the past 10 years. What about the past 30 years? The chart shows that the earnings yield on US equities (“US EY”) is close to the average that has prevailed over the past 30 years. 6% is also close to our assessment of equilibrium, or the average that we might expect to receive from investing in equities over many years. We could conclude from this that valuation is neutral in an absolute sense. The chart also shows the negative real yields on bonds and cash in the USA.



The third and final way to assess markets (and arguably the most important way) is to look for evidence of behavioural influences. If we can find evidence of the mirror opposite of the gloom that prevailed six years ago it might lead to the conclusion that equity markets have gone too far. But in fact the opposite is true! Despite the returns that have been delivered investors appear to be still scared of buying equities. Of course there are pockets of the market where expectations are elevated – so called “quality” stocks (high ROE, stable earnings, strong balance sheets with low financial leverage) have performed well and are well loved. Stock prices have risen more strongly than underlying earnings which means that the deliverable return going forward on these stocks is lower than it was before. But away from such pockets of higher valuation investors are still reluctant to pay up for growth or hope of future earnings.

There are some commentators who are currently bearish about the outlook for equities and their arguments are based on the idea that the re-rating has gone too far and that, in the case of the US, profit margins are high and must mean revert. How seriously should we take those concerns? We do need to remember that the same people saying such things have been saying them for a while (see 10th Jan 2014 blog – has the US rally gone too far? One day it will be right to be worried about the valuation of US equities – but at that stage it is more likely that market sentiment is bullish, not cautious.

The very fact that investors are prepared to lend to governments at low or negative yields is itself a sign that they are nervous of the potential volatility of equities. The equity risk premium is a very powerful measure of relative valuation for multi asset investors. It’s not giving as bullish a signal as it did a few years ago when it hit 9%, but it does suggest that the relative attractiveness of equity is still meaningful. Outside of the US, equity risk premia are in many cases even wider, further strengthening the case for preferring equities to bonds. Equities have done well of late, but there is a long way to go until we get anywhere near 1990s relative valuation conditions!


The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.