It’s a relative call. It’s a quirk of the market that we all look at things on a price to earnings basis… What you need to consider when you think about asset classes being cheap against one another is how they look compared to global yields and primarily bonds. Right now the extra yield you get for investing in equities relative to bonds is the highest it has been in decades…
It’s an argument we’ve heard many times over the past month, from brokers, economists and investors alike. Like many dangerous ideas it has just enough truth in it to be convincing. The yield on earnings from shares is indeed at historic highs compared to what a bond will pay, and that extra yield, known as the 'spread', is an important consideration.
But the spread is also far from the complete picture. A ten year bond will deliver you flat a coupon and your fixed principal back in a decade. An investment in Telstra shares, as an example, paying a 4.9% dividend delivers you an open-ended stream of dividends that will hopefully grow in time and no guaranteed principal return, ever.
At a dividend yield of less than 5%, the present value of the next ten years dividends accounts for less than half of Telstra’s share price. So your actual return is going to be significantly dependent on Telstra's profitability and, perhaps more importantly, interest rates in 10 years' time.
The long term nature of the cash flows means shares, compared with ten-year bonds for example, are far more sensitive to long-term real interest rates. Warren Buffett summed it up perfectly at Berkshire’s annual meeting:
At normal interest rates, stocks at these prices will look very high. But if we continue with these low rates stocks will look very cheap.
If interest rates stay low for a long, long time, then comparing the yield on shares to the ten-year bond rate is fair. But that’s far from guaranteed. Sensible investors need to leave room for the potential that interest rates revert. You can pay a little more for Telstra because of low interest rates, but not too much.
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