Which asset class represents one of the most complicated forms of derivatives? Equities, of course.
Equities are a call option on the assets of a company, where the exercise price is the payoff cost of the debt. To put this more simply, equities represent a claim to whatever is left over (or may be left over in future years) on a company’s balance sheet after all debts (to the government in the form of taxes, the employees as salaries, to trade creditors, and to secured and unsecured debt holders) are paid off. Like any option, equities are highly sensitive to a number of assumptions – such as the volatility of company earnings, interest rates, tax rates, to name just a few.
Of course in recent years equities have been valued as whatever you wanted them to be – particularly during the dot-com boom, when the ability of investors to extrapolate into the future (wasn’t it called “blue-sky thinking”?) meant that prices could rise almost infinitely.
Now that markets have returned to a much more sober mood, the tougher job of trying to value those complicated derivatives, called company shares, has returned to prominence.
With the headlines in today’s UK papers reminding us that yesterday’s 1.5% cut in interest rates takes us back to the levels of the early 1950s, it’s worth reminding ourselves that the 1950s saw a groundbreaking shift in the financial markets, one which is of great relevance to our task.
I refer of course to the disappearance of the “yield gap”, where equities yielded more than bonds. So unaccustomed were financial market professionals to equity yields moving below those of bonds – after all, equities were riskier than bonds and should yield more, shouldn’t they? – that they referred to the new relationship as the “reverse yield gap”. In other words they didn’t expect it to last. But it did, right up until…about now, fifty years later.
Here’s a table of the current level of equity index dividend yields, and ten year government bond yields, in some of the major markets. I’ve taken the data from the http://www.ft.com/ website.
| Country |
Equity Yield (%) |
10 year Govt. Bond Yield |
| UK |
5.8 |
4.2 |
| US |
3.1 |
3.7 |
| Japan |
2.3 |
1.5 |
| Germany |
4.1 |
3.7 |
| France |
4.8 |
4.1 |
As we can see, the pre-1950s “yield gap” has reappeared in four of the five markets, with equities yielding more than bonds everywhere except in the US. The margin is greatest in the UK, with equity yields a full 1.6% above those of bonds.
So aren’t equities now a screaming buy?
There are a couple of immediate caveats. First, one should really use corporate, rather than government bonds for the comparison, and these are yielding substantially more than the government versions. Second, dividend yields are in many cases due to be cut, and the equity index yields are therefore overstating equities’ attractiveness. In the UK, for example, banks’ dividend yields run well into double figures, even though most payouts are about to disappear.
But, looking more deeply, there is also the problem of debt. With so much sloshing about the global economy, and the explosive rise of the derivatives markets, structured finance and off-balance-sheet financing, in many cases it is unclear what liabilities a particular company faces. If you have a clear head and half an hour free, here’s a single example from a UK corporate as to how complicated these relationships can become (courtesy of FT Alphaville).
In other words, returning to our equity as option analogy above, for very many companies it’s very hard to work out exactly what the debt payoff price is. And, if we don’t know this, valuing equities becomes the most difficult task of all.
Taking all this into account, it’s no wonder that equity prices have been so volatile recently. The VIX levels of early 2007, when the indicator fell below 10, now look like an amazing, and incomprehensible anomaly.
And so while the reappearance of the yield gap makes equities look very cheap to anyone schooled in the last few decades of investing, a longer-term perspective doesn’t give such a clear-cut answer. So to have an ETF portfolio heavily overweighted in equities, even at current valuation levels, is still a very risky position indeed. Perhaps the post-1950s “cult of the equity” is really dead, after all.
