My Diary 475 --- Everything you knew about bonds and equities

Everything you knew about bonds and equities: anomalous

Forget trying to pick a bottom in this crisis. One of the more painful lessons equity investors will learn is that it makes little sense to try and be ahead of the game this time around. In fact, in the words of Albert Edwards, “they can afford to be late.”

How late, of course, is the question. The Japanese are still waiting.

Next year, the dividend yield for the market as a whole will soar above the bond yield (as it has in Japan). This has always been THE key point of our Ice Age thesis. 

… equities will NOT bottom out ahead of the economy. Those who buy equity indices before the economic bottom, will be relying on the powerful, +76.7% bond/equity yield correlation between 1970-1999.

(For a short explainer of the Ice Age thesis, start here.)

A correlation which has actually been negative 78.2 per cent since 2000. The broader picture is that this is the reversal of a 50 year relationship, one in which bond yields have been above equity yields. That trend is now about to be undone, by Edward’s estimation.

Edwards points to a post by Peter Bernstein, which is worth reading. If nothing else, it’s enlightening because it points out that what appear to be fundamental relationships in the market can and do change. Bernstein is 89. So he was around in 1958 when bond/equity yields last inverted. Back then it was the reversal of a seemingly immutable relationship too.

A profound philosophical dilemma is present here. The yield inversion in the spring of 1958 taught me a lesson I have never forgotten: anything can happen. Just because a relationship had held since the beginning of time is no reason to believe it would also hold until the end of time. Black swans lurk behind every shadow, and we should always be prepared for unimaginable outcomes - unknown unknowns. My older partners may have been mistaken for half a century when they confronted an unknown unknown in 1958, but even a time span of fifty years was no guarantee they were going to be mistaken unto eternity. I, for one, shall not be surprised if the inversion is reversed in the near future, nor shall I expect that reversion to last into the indefinite future.

This entry was posted by Sam Jones on Wednesday, November 12th, 2008 at 15:49 and is filed under Capital markets. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.