The disconnect between bond yields and stock prices this summer has caused more than a bit of head-scratching. Conventional wisdom says the two should move hand-in-hand, yet bond yields have tumbled while equity prices have largely drifted sideways.
Some market watchers have argued that the divergence reflects a disagreement between the bond and stock markets over growth prospects, and more specifically over deflation versus inflation. Regardless, the assumption is that one of these markets must be "wrong," and that eventually it will have to correct itself.
But Citigroup suggests that the recent disconnect is just a symptom of a much bigger long-term drift by investors away from equities and back toward bonds - the end of the so-called "equity cult."
THE EQUITY CULT
The equity cult refers to a shift in investor tastes in the second half of the 20th century away from bonds and toward equities. This change is evident looking at fixed-income and dividend yields (essentially, how much the markets compensate investors for their investments) from 1960 onward; dividend yields fell below 10-year U.S. government bond yields, and stayed far below them for the better part of 50 years.
Why? Citigroup's global equity strategy team said in a report this week that the relative global stability of the era and the rise of modern portfolio theory convinced investors that equities - far from being the higher-risk option - could actually deliver superior returns with lower risk if the portfolio was diversified. The popularization of this theory fuelled a widespread shift in asset-weighting among money managers, away from bonds and toward equities - which, ultimately, became self-perpetuating as the flow of funds drove equity prices higher and produced spectacular out-performance over bonds.
But in the past decade, the tide has turned. Thanks to two dramatic slides in the equity market in less than 10 years, returns from the stock market have evaporated while volatility (hence risk) has increased. Institutional investors have reversed course, shifting away from stocks and back toward bonds, and the gap in yield spreads has been wiped out.
WE'VE ONLY JUST BEGUN
Now, the Citigroup strategists said, the cult of equity is being replaced by a "new cult of the bond," as bonds look more compelling in a deflation-sensitive world and in Western economies where the populations are tilting increasingly toward retirement age. And they added that the tidal shift could have a lot further to go.
Though U.S. private-sector pension-fund equity weightings have retreated from almost 70 per cent in 2005 to just over 50 per cent now, they're still far above their pre-1959 levels of less than 20 per cent. Were they to revert to their pre-cult levels, the strategists said, "For U.S. private-sector pension funds alone, that would imply a further $1,900-billion [U.S.] reduction in equity weightings."