Shore Capital says it’s time to get aggressive on equities as the bond bullishness has reached a plateau (via Bloomberg):
Investors should favor stocks over bonds, according to a gauge based on the relative value of the two asset classes which correctly signaled the rally in equities that began in March last year.
The monthly gap between the earnings yield of S&P 500 and the 10-year Treasury yield, adjusted for historical volatility, as calculated by Shore Capital. July’s reading was minus 0.32, down from as much as 1.26 in May. A negative reading is bullish for stocks, while a positive one suggests bonds are more attractive.
“Equities are no longer overvalued, as they were at the start of the year,” Gerard Lane, a London-based strategist at Shore Capital, said in an interview. “Given the rapid decline in government bond yields, based on trend earnings this signal is suggesting a switch from bonds to equities.”
(Chart courtesy of Surly Trader)
This is not merely a story of oversold or overbought, however. Surly Trader discusses the pertinent theme here:
“At the heart of whether equities look more attractive than bonds is the question of whether inflation or deflation will emerge within the next few years. If we believe in the Japanese outcome, then the wise have prevailed and corporate bonds will save the day. On the other hand, if inflation is sparked by renewed growth and the Fed’s fuel on the sparks, then an investment in 10 year treasuries at 2.6% will be an embarrassing trade. My vote is on the latter.”
Betting on another lost decade? I don’t think that’s so wise. Even the worst of my projections say the debt de-leveraging (and deflationary cycle) ends well before 2020. Even as a deflationist who has called this macro environment more accurately than most I have to admit that buying a 10 year at 2.5% and holding to maturity looks like a terrible bet. On the other hand that doesn’t mean government bonds won’t continue to be a good bet in the coming years as we remain mired in a balance sheet recession that elevates market/economic risks and keeps a lid on near-term inflation risks.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.