Peter Temple on... The coming yield gap

It's time for a scary history lesson.

Let's start from the premise that historical perspective is best measured over a longer time perspective than the last 20 years. Many historians regard the history of the 20(superscript: th) century as a little 'arriviste'. And the late Chinese premier Zou en lai, when asked about the significance of the French Revolution, was reported to have said 'it's too early to say....'

Selective memory

Most market commentators treat the history of the markets as though nothing happened before 1980. Often its because they can't be bothered digging out the data for eras before that. But arguments based on so short a time span can be hazardous to your wealth.

Here's a case in point. There is an argument currently doing the rounds that the equity market must be cheap because the gap between equity yields (currently 3.5% in the UK, much lower in the US) and bond yields (currently around 4.5% for five year bonds, and again much lower in the US) has narrowed to historically low levels.

Back to the future

I'm afraid I have news for you. In fact this particular yield gap is more correctly known as the 'reverse yield gap'. Before the cult of the equity
developed in the late 1950s, equities traditionally yielded more than bonds because they were considered to be riskier, a view that today's share investors could probably relate to. Before this, the yield gap was normally measured the other way round, how much more equities yielded than bonds.

I would argue that the period most nearly approximating to where we are now in the market is 1931, two years after the end of the great 1920s bull market. So what dividend equity yields and bond yields tell us then?

The answer

I turned up one of my old textbooks to get the data, and it goes something like this. In the early 1930s yields on the S&P industrials stock index rose to close to 8% at their peak, while AAA rated corporate bond yields were 5% and falling. From 1936 to 1958 equity yields fluctuated between 4% and 7% and bond yields between 2.5% and 3.5%. At no time in that 22-year period did equities yield less than bonds, and for most of the time they yielded substantially more.

Indeed the only reason equities yielded less than bonds between 1933 and 1936 was probably because of massive dividend cuts in many of the stocks that made up the index. And US government bonds in the same period were on yields between 0.25% and 0.75% below corporate bonds. That is what's meant by a yield gap in a depressed deflation-prone economy.

Keeping it real

But let's also look at real returns, perhaps a more objective way of measuring. Taking 1929 as the start year, it took until 1945 for the average returns on equities to exceed those of government bonds. Over this period the average annual returns on the pairs of investments were in the region of 5.5% in real terms in the UK and 4.2% in the US.

This is what we have to look forward to and it implies substantially lower share prices in the short and medium term. So say goodbye to the reverse yield gap until 2010. How bad could it get? Between the end of 1930 and the end of 1940, equities had a total returns (dividends plus capital growth) of just 2.5% a year in real terms and 3.5% in the US; risk-free government bonds produced 4.0% a year in real terms in the UK and 6.5% a year in US.

Where do you want to invest? As they say, it's a complete 'no-brainer'.

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