The arguement against equities

ALBERT EDWARDS has ploughed a lonely furrow as a strategist. He turned bearish on the stockmarket more than 10 years ago, just before the dotcom boom that took share prices into the stratosphere. And to confirm his penchant for bad timing, he recently switched jobs from Dresdner Kleinwort to Société Générale, just in time for the Jérôme Kerviel trading scandal.

But for investors who take the long-term view (and that is usually advisable) Mr Edwards’s advice hasn’t been that bad. Since he first made that bearish call on equities, they have (just) been outperformed by government bonds. And, of course, bonds have been a lot less volatile than shares along the way.

The core of Edwards’s argument is that stockmarkets are entering an “ice age”, in which the prospect of slow earnings-growth would lead to a decline in valuations. During the long bull market (which stretched from 1982 to 2000), equities benefited from declining inflation. The yields on most asset classes fell and, since yields have an inverse relationship with prices, stockmarket indices rose sharply. It helped, also, that the corporate sector benefited from a rebound from the difficult conditions of the 1970s, when it faced disruptive trade unions and rising raw materials costs.

But when it comes to low inflation, it may be better to travel hopefully than to arrive. The corollary of low inflation is low nominal earnings growth. However, analysts’ long-term profits expectations failed to decline in line with the inflationary picture.

This was most noticeable in 1998 and 1999. Profits as a share of American gross domestic product (GDP) had already started to decline. But optimism (and some accounting manipulation) meant that the same trend did not show up in the profit numbers reported by quoted companies.

That is why the bear market of 2000-2002 was so severe. Analysts had not only to adjust their profits forecasts but reduce the ratings they were willing to give companies on the back of those profits. Since then, the world has seen a substantial profits revival, but that may be due to the temporary strength of financial sector profits in a period of low interest rates and rapid credit expansion.

At the heart of this issue is the so-called “Fed model”, which has been widely used as a valuation measure for shares. The model compares the medium-term government bond yield with the prospective earnings yields (the inverse of the price-earnings ratio) on the stockmarket. If the earnings yield is higher than the bond yield, then shares are cheap. And if bond yields fall, then share prices should go up. The model appeared to work well as a timing indicator for the 1978-1996 period covered in a Federal Reserve paper.

But there is a theoretical problem with the model. What does it mean if government-bond yields fall? It may simply mean that inflation expectations have reduced. If it has, then expectations for the nominal growth rate of corporate profits should fall in line. Shares should be no more attractive than before.

One answer to this problem is to use real (or index-linked) government-bond yields in the comparison. But what does it mean if real bond yields fall? It means that expectations of real growth in the economy have declined. And if that is the case, then expectations for profits growth should have fallen in line (since profits cannot, in the long run grow faster than the economy). So lower real yields shouldn’t help equities either.

There is a good practical example of this issue in Japan. Japanese government-bond yields fell steadily through most of the 1990s, bottoming out at 1-2%. The earnings yield has been higher than the government bond yield throughout this decade, but that has not made the Tokyo stockmarket a good buy.

Mr Edwards argues that investors have been lulled into a false sense of security that equities are cheap. They may look cheap relative to government bonds, but that measure is irrelevant. They may look cheap in terms of prospective profits, but profits expectations are inflated. Compare share prices with a 10-year average and equities look as expensive as they did before the 1929 crash. Factor in the possibility of a severe recession, rather than the mild one most economists are expecting, and investors could be in for a nasty shock.

Mr Edwards has not yet been proved right over the last 10 years. But he has not been proved wrong either. Equities have been de-rating for several years. Who is to say the process has stopped?