SERIOUS MONEY:Bull and bear markets are precipitated by movements towards or away from price stability
MORE THAN half a century ago, in the summer of 1958, the dividend yield on stocks fell below the yields available on long-term treasury bonds for the first time since the heady days of 1929 when the crossover lasted only briefly.
Experienced investors reacted cautiously and Business Week penned an article entitled “An Evil Omen Returns”. It noted that whenever the dividend yield on stocks and bond yields had converged, stock investors had been well served to reduce their equity exposure.
One month later, the same publication suggested that “the relationship between stock and bond yields was clearly posting a warning signal”. In the 12 months that followed, the stock market climbed 30 per cent and continued to generate strong returns into the early 1960s.
The bears proved wrong as the supposed anomaly persisted. Those who remained on the sidelines waiting for a reversal missed real returns of 7 per cent per annum through the remainder of the 20th century.
Fast forward to today.
Conventional wisdom has been shattered once again as the 65 per cent decline in real stock prices since the spring of 2000 has seen the dividend yield on stocks rise above long-term interest rates for the first time since before the seminal crossover more than 50 years ago.
Furthermore, the widely accepted positive correlation between the dividend yield and long-term interest rates has also crumbled and turned negative. Indeed, the coefficient of correlation since the end of 1999 has been an impressive -0.76 with statistical significance.
What explains the breakdown in conventional wisdom? The answer appears to rest with the trend in long-term inflation expectations and the movement away from or towards price stability.
It should be highlighted that inflation per se should have no impact on the valuation of stocks because they are a claim on real cash flows and both dividends and earnings can be expected to increase in line with changes in the price level in the long run before any consideration of real growth.
Prices provide consumers and producers with the information they need to assess the relative value of goods and services, which ensures that resources are allocated to their best uses. However, the information content in prices declines significantly when the aggregate price level changes unpredictably.
During periods of malign deflation and high inflation, it becomes difficult to distinguish between relative prices that are advantageous and those that are disadvantageous.
The historical evidence shows that both malign deflation and high inflation lead to greater economic volatility and, consequently, individuals require additional compensation for investment in stocks or higher dividend yields and lower price/earning multiples.
Secular bull and bear markets are precipitated by movements towards or away from price stability. The yield crossover in 1958 occurred as investors recognised that the preceding recession was the first time post- second World War that an economic downturn had not been accompanied or followed by a declining price level and concern that a repeat of the Great Depression lay in wait was finally put to rest.
Unanticipated inflation proved good for stocks as the secular bull market that began during the summer of 1949 saw the dividend yield drop from almost 7 per cent to below 3 per cent by 1966 even though long-term interest rates more than doubled to 5 per cent over the same period.
Long-term interest rates and dividend yields moved in the opposite direction because bonds are a claim on nominal cash flows and unanticipated inflation had a negative impact on their valuation while the movement towards price stability caused a reduction in the risk premium attached to stocks.
Price stability came to an end in the late 1960s and early 1970s as accommodative monetary policy, expansive fiscal policy and a collapse in the Bretton Woods system of fixed exchange rates all contributed to runaway inflation.
The positive relationship between dividend yields and long-term interest rates that has been accepted as conventional wisdom came into being.
The yield on treasury bonds jumped from 5 per cent in the mid- 1960s to 14 per cent in 1982, while the dividend yield on stocks increased from below 3 to almost 7 per cent. The risk premium attached to stocks rose due to greater economic volatility while upside inflation surprises saw bonds register negative real returns of more than 3 per cent per annum over the period.
Both bonds and stocks recorded impressive bull markets during the 1980s and 1990s as the Great Inflation gave way to disinflation and a return to price stability.
However, they parted company nine years ago as deflation concerns came to the fore, leading to a fundamental reassessment of the risk premium attached to equity investments.
Bonds have outpaced stocks by more than 12 percentage points per annum since the end of 1999 but a reversal of fortune for equity investors seems unlikely as the holy grail of price stability seems unlikely to return anytime soon.
The secular bear market is not over and conventional wisdom is likely to remain broken.
charliefell@sequoia.ie
