Out of equities into bonds: is there a better option? (page 1 of 2)

Though we have the occasional respite in global equity markets, the long-term prognosis still looks grim.

Valuations look stretched and if one adjusts core earnings for un-funded pension liabilities and for executive options - an adjustment of a further 40% in the case of the S&P500 - valuations look even more unrealistic, with p/e ratios above 50 for the S&P500, four times the historical fair value.

On the positive side, by the second quarter we could see signs of investment-led growth, but even with the most optimistic assumptions of performance one is struggling to reach beyond 5% or 6% dividend yield on US equities.

The picture looks a little better in European equity markets, though weakness in the US stock market can be expected to drive sentiment there too.

In contrast, and in large part due to large allocations to domestic equities, pension funds both sides of the Atlantic are seriously under-funded and many require an 8% or 9% return in the future to meet actuarial liabilities. The optimists, of whom there appear to be plenty, may invoke tactical logic for remaining in equities for now.

If equities do well in 2003 it will indeed most likely be due to portfolio rebalancing (by which under-performing asset classes like equities are the recipients of new inflows from pension funds so that their target allocations are maintained) and/or due to the seeming lack of alternative homes for funds to go to. Both are short-term and negative motivations, but what are the alternatives?

Then again, why should optimism over equities be seen as short-term and negative? Rebalancing is justified in mean-reverting markets. The reason is we may now be in a secular bear market. To determine whether this is the case and hence whether optimism may be justified after all, we should consider not only current valuations, but also the history of financial markets and secular trends.

Equities were not always king - bond markets developed first and were more dominant even for retail investors for centuries until the second half of the 20th century. The equity premium is not written in stone, and there have been many periods when bonds have for long periods outperformed equities.

Moreover, there appears to be a theoretical as well as empirical relationship on the one hand between fixed exchange rates and low inflation/deflation with bond out-performance, and on the other hand between floating rates, inflation and equity out-performance.

The picture going forward is not clear, because we still have floating exchange rates (although not inside the Eurozone), but we do seem to be in a world of low inflation now. Hence many are questioning the ability of equities to outperform bonds over the next ten years and more.

The consequence is a thorough review of allocation weights. If one believes debt may outperform equity then this would justify a 60-70% weighting in bonds and 30-40% in equities, not the other way round as at present. The fact that allocations only move slowly and gradually (because decisions are intermittent and staggered across the industry) means such an adjustment may take a long time. In the meantime, money may be slowly pulled away from equities, potentially capping upside for years.

However, G7 government bonds do not look particularly attractive either. Global interest rates are low and expected to turn up at some point, even if this now may have to wait until next year. G7 bonds are not going to reach that 8% or 9% actuarial return either, even if they are relatively attractive compared to equities and not expected to lead to further major losses.