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Equities versus bonds: Which offers better value?

05 June 2009 Dr Prieur du Plessis, chairman of Plexus group
Dr Prieur du Plessis, chairman of Plexus group

Dr Prieur du Plessis, chairman of Plexus group

Investment managers of balanced portfolios use myriad fundamental and technical indicators when determining their portfolios' allocation between equities, bonds, property and cash.

The decision regarding whether to overweight or underweight equities has become somewhat more difficult, following a 27,3% rally in domestic equity prices since the FTSE/JSE All Share Index hit a low of 18 121 on 3 March, says Dr Prieur du Plessis, chairman of Plexus group.

“One way to gauge whether equities are cheap or expensive is to compare their valuations with those of other asset classes,” says Du Plessis. “To establish where equities are trading relative to bonds, one can compare the earnings yield on equities with the yield on long-term bonds.”

According to Du Plessis, the earnings yield on the FTSE/JSE All Share Index is currently 9,2%, having declined from 12,4% on 3 March due to the recent significant rise in share prices. Despite the substantial decline, the current earnings yield is still considerably higher that the long-term average of 7,5% since 1989.

The yield on the All Bond Index is currently 9,5%, reflecting the up-tick in long-term bond yields since their 18 December 2008 low of 8,9%.

“To compare the relative value of equities versus bonds, one should look at the difference - or spread - between the yields of the two asset classes (i.e. the yield on the BESA All Bond Index minus the earnings yield of the All Share Index),” says du Plessis. Currently the spread stands at 0,3%.

“Although the spread has narrowed significantly from -3,0% since the market low of 3 March, it is still far from the 5,1% long-term average since 1989,” says Du Plessis.

Bond yields are almost on par with the earnings yield of equities, however, the earnings yield of equities is still significantly higher than the long-term average and bond yields are close to a low not seen in more than 20 years. He says “it is hard to come to any conclusion other than that equities are still cheap compared to bonds.”

“Even though the recent equity market rally may prove to be a case of too much too fast and a short-term pull-back may be on the cards, there are signs that the pace of the global economic meltdown is slowing and that some green shoots are appearing. At current levels there is good potential for capital growth from equities over the next few years,” says Du Plessis.

He believes bonds “have already discounted a very gloomy economic picture and more interest rate cuts by the South African Reserve Bank. South Africa also still has inflation to contend with, which although on a declining trend, remains stubbornly high.”

“With this in mind, there is little chance of significant declines in long-term bond rates and the potential for any capital growth over the next year or two is therefore limited,” says Du Plessis. “With an expected mild improvement in the global economy during the second half of this year, leading to higher commodity prices and an improvement in the domestic economy, we may even see long-term bond rates rising and bond prices declining.”

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