THE REVERSE YIELD GAP RE-EMERGES
Clearing out some archives the other day, I came across a research paper written in 1978 on the subject of the relationship between equities and bonds. The Yield Gap (ie. the spread between the equity and bond yield) was of course a staple relative valuation measure until it became the Reverse Yield Gap in 1958. In recent years, as bond yields plunged, it again became, at least until very recently, the Yield Gap but it seems that investors do not pay it the same attention.
I do not know the author of the paper, except that his (I assume his) initials were ebd and that it was written on behalf of the Common Stock Research Committee, by which I imagine he was American. I reproduce below the historic path of the Yield Gap until 1978 but perhaps what is interesting is the conclusions he drew.
The first is that bond and stock yields usually move in the same direction, at least in the long term. The author acknowledges that in the short term that may not be the case; in contrast I can remember as a graduate trainee a senior bond manager describing an afternoon when both equity and bond yields fell in unison following an interest rate cut as being ‘unusual’.
He thought that the reverse spread was a reaction to increased fears of inflation following the 1957 recession, which unusually did not create deflation. He suggested its persistence was due to higher return on equity and he quotes 13.8% for the period 1973-1978. Today both inflation and returns on equity have fallen, so he would correctly have predicted the 2008 re-emergence of the Yield Gap in place of the Reverse Yield Gap. My old professor at the London Business School, Paul Marsh, theorised that the Yield Gap should be the expected risk premium on equities minus the growth in dividends. But, as he pointed out, we can only observe the equity risk premium in retrospect.
Ebd did not believe that inflation was a significant factor in equity markets, citing that two major bull markets had been in deflationary conditions and one during inflationary times. We can broadly add further bull markets in deflationary times in the 1990s and since 2009, so might choose to disagree with him on this point.
Perhaps most interestingly, writing at a time when the biggest bull market in history was about to begin and the Reverse Yield Gap was extreme at 384bps, he didn’t believe that stock prices were either ‘grossly underpriced or overpriced’.
Today we again find ourselves with a Reverse Yield Gap, albeit small at 20bps (US 10 yr bond yield at 2.1%, S&P 500 1.9%), ie. just outside the long term range showed in the chart below. Does that make equities ‘neither grossly underpriced nor overpriced’? It is worth noting that if bond yields were to go to the upper end of the historic Yield Gap range they would have to rise by about 200bps compared to equity yields. Or are we too at a turning point and unable to see a major inflationary sea-change approaching, much as in 1958?