1929 or 1959?: How Much Value is Left in Equities

An article by New York Institute of Finance Portfolio Management instructor Paul Temperton.

World equity markets have had a good run recently and when that happens it is always sensible to step back and take a hard look at valuations. Have equity markets got too carried away? Are investors at risk of making the perennial mistake of buying too late – once they feel more confident – when the best opportunities have disappeared? History is a useful guide at such points in time. The essential question, in a long-term perspective, is whether we are at a 1929 or a 1959 moment?

A 1929 moment?
The dividend yield on the US S&P500 equity index (dividends paid over the previous twelve months relative to price) and the yield on 10-year Treasury bonds can be tracked all the way back to 1871. That is thanks to the work of Robert Shiller (of ‘Irrational Exuberance’ fame) and the generosity of the kind people at multpl.com who provide his data, along with their daily updates, for free.

From 1871 to 1958. The dividend yield on equities was, almost all the time, above the Treasury bond yield. The generally accepted view was that a positive ‘yield gap’ was justified because of the greater risk of equities relative to gilts. Specifically, dividends could be cut and were discretionary whereas coupon payments on bonds were fixed. Treasury bonds were ‘safe’ and a premium was required to entice investors into the riskier world of equities. You’ll hear many people saying similar things nowadays.

In that long period there were several occasions when the dividend yield on equities dropped to around the same level as the Treasury yield. On each occasion that spelled trouble for equities. It was a sign that equities had become overvalued. The most (in)famous example was 1929. On 1 January of that year the dividend yield on equities dropped to just 3.46%, marginally (14 basis points) below the Treasury bond yield. Of course, the equity market continued to rally for a few more months but we all know how the story ended. It was a disastrous time to buy equities: it was not until New Year’s Day 1956 that the real value of the S&P500 regained its 1 Jan 1929 level.

Or 1959 all over again?
By 1959 confidence in equities had been restored and the equity dividend yield dropped below the Treasury yield. But this time, far from providing a ‘sell signal’ this marked the start of the ‘cult of the equity’. Or, less elegantly, the ‘reverse yield gap’. Sometimes it is the case that ‘this time is different’. 1959 was one of those times. Equity dividend yields stayed below bond yields all the time until 2009. The arguments, now familiar, were that over long investment time horizons equities had produced superior returns to bonds and could be expected to do so in the future. In particular, company earnings and dividends could grow over time as the economy grew; but coupon payments on fixed interest securities were, well, fixed.

2008 onwards
The yield gap re-emerged as the global financial crisis engulfed markets after 2008. Nervous investors preferred the ‘safe haven’ of Treasury bonds; the Fed became an enthusiastic buyer of Treasuries under its QE programmes; and equities were abandoned. As the S&P500 bottomed out at 666 in March 2009 many predicted a further halving.

Where now?
So, where do we go now? On 20 May 2013, the dividend yield on the S&P500 index (at just over 2.0%) was marginally higher than that on the 10-year Treasury bond (just under 2%). Is it a 1929 moment – a sign that equities are overbought and due a sell off? Or another 1959?

US Dividend and Bond Yield: Recent History

For three reasons it looks more likely that it will ‘be a 1959’ with a move back to the ‘reverse yield gap’. First, Treasury bond yields may well rise further as QE draws to a close and the US economic recovery continues. Second, that recovery will mean there will be greater confidence in the ability of companies to grow earnings and dividends. Third, on other measures of equity valuation the US market does not seem expensive. The trailing P/E ratio is 16.7 – by no means cheap – but nothing to set alarm bells ringing.

Let’s party like it’s 1959.

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