Inside investment: Equity alive and kicking
Reports of the death of the cult of equity might have been exaggerated. For those with intestinal fortitude, stocks offer both relative and absolute value. The current bull market might still be in its infancy.
1956 was a year of turning points. Elvis Presley had his first chart success with Heartbreak Hotel, the Suez Crisis marked the beginning of the end of British superpower status, Norma Jean Mortenson became Marilyn Monroe, Johnny Rotten was born and Fidel Castro set sail for Cuba from Mexico. In the rather less exotic setting of the wharfs of Bristol in the southwest of England, an investment revolution was also taking place.
George Ross Goobey, the manager of the Imperial Tobacco Pension Fund, was using his charm and formidable intellect to persuade a sceptical board of trustees that the time was right to sell out of bonds and buy the stock market. His heretical view was shaped by a combination of negative real interest rates and equities offering a higher yield than gilt-edged stock (4% against 3%).
This reverse yield gap was also present in the US. The fear of holding equity after the crash of 1929 and the Second World War meant that investors demanded yield to protect them from perceived risk, regardless of potential capital gains. This ought to sound all too familiar. The financial crisis has seen government indebtedness rise to levels unprecedented in peacetime. Monetary accommodation and experimentation have pushed the real yields on safe-haven sovereign debt into negative territory.
The hunt for income has also led corporate bond yields to fall to historical lows. Not only do equities yield more than government bonds, more than half of the companies in the Stoxx Europe 600 have a yield higher than the iBoxx investment-grade credit index. Yet equities remain unloved. That is hardly surprising when over the past decade all that many developed stock markets have delivered to investors are two bear markets, gut-wrenching volatility and no returns.
The ubiquity of this fear and loathing is remarkable. Crunching the numbers from the Investment Companies Institute in the US reveals that since the onset of the credit crunch in August 2007, the net outflows from equity mutual funds have totalled $514 billion. In the same time period, US investors have snapped up more than $1 trillion of bond funds.
In Europe, the figures are remarkably similar. Ucits equity funds have seen €500 billion of outflows. UK pension funds have their lowest allocation to equities since the 1980s, 42%, down from a peak of more than 70%. In spite of the rise of ETFs and high-frequency trading, volumes have collapsed at the main stock exchanges around the world.
Meanwhile, bond euphoria shows no signs of abating. Last month, Comunidad Autonoma de Madrid, a Spanish regional government, raised all the finance it needs for 2013 in a public bond auction and private placement on the same day. Only a few months ago the bond markets were closed to Spanish issuers – even those, such as Madrid, with the same rating as the sovereign.
So long as debt is cheap, governments will be able to ameliorate the hangovers from the financial crisis, and negative real rates have the happy side-effect for debtors of inflating away their obligations. This should force investors to look for assets offering a real return.
Cheap funding is also a boon for companies and, potentially, stock markets. If debt is cheaper than equity, it makes sense to use the former to buy back the latter. This is corporate finance 101 (Modigliani-Miller, for the more theoretically minded). It also makes M&A attractive. In January, for example, Ardagh, once an Irish also-ran in bottling, acquired Verellia North America from Saint Gobain for $1.7 billion. It was Ardagh’s second big debt-funded acquisition.
The world’s top 500 non-financial companies have $4 trillion of cash on their balance sheets. KPMG’s global M&A predictor shows corporate appetite for deals has risen in line with their capacity to transact. Of course, companies might use the cash to fund capex. Although shareholders might not benefit directly, this would still be a plus for the real economy via consumption, productivity or employment.
The debate over whether or not bonds are too expensive must wait. What is clear is that equities look cheap. Using a cyclically adjusted price/earnings ratio suggests that UK and continental European stocks are a rare bargain in historical terms.
US equities are less compelling by this measure. But one of the best guides to the fate of the S&P500 is what is happening to median house prices. With 30-year mortgages available at 3.5% and the loan-to-value ratio at 95%, the US housing recovery looks well supported. The biggest barrier to stocks taking off is largely psychological. It was ever thus. Every bull market for the past 130 years began with sentiment depressed.
My knowledge of George Ross Goobey does not extend to his taste in films. But on the occasion of his meeting with the Imperial Tobacco’s pension fund trustees, perhaps he was humming I Whistle a Happy Tune, the first number from the biggest hit of 1956, The King and I. The lyrics include these lines: "Make believe you’re brave/And the trick will take you far/You may be as brave/As you make believe you are." Investors looking for real returns should try it and overcome their dread of equities.
Andrew Capon has won multiple awards for commentary and journalism on markets, investment and asset management. He welcomes comments from readers and can be reached at firstname.lastname@example.org