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Stock markets have a lot to be concerned about, its 10-years on from the GFC and things are starting to look a bit more negative again. Economic data is weakening around the world and is expected to continue to worsen; Central banks are abandoning any talk of raising interest rates and are instead sending rates back towards record lows in an attempt to promote economic activity; The world’s two largest economies are facing off in a trade war; and a yield-curve inversion, often seen as a harbinger of a recession, has been seen in many government bonds.

It may be surprising to some that given all of this, Australian share prices are trading at a high 16.1 times forward earnings (vs an average of 14.2 since 2002). So why are shares so historically over-priced relative to their earnings?

Well, one answer lies with the historically low interest rates, which has translated to low government bond yields. The government bond yields are sometimes considered a default or risk-free return, and when it is low, it means that the returns on other assets can also go lower.

For example, if you can get a 5 percent return in a government bond, you may not be willing to invest in a stock yielding 6 percent – because the 6 percent is not overly attractive when you can get a fairly safe 5 percent return. However, if the government bond yield drops to 1 percent, you may now be happy to invest in that same stock even if it is yielding just 4 percent now. Therefore, as bond yields drop, investors should buy up stocks to force stock yields down as well.

The distance between stock yields and bond yields is call the equity-to-bond yield gap. And according to Paulo F. Maio, of the Hanken School of Economics in Helsinki “the yield gap forecasts positive excess market returns, both at short and long forecasting horizons” and that “it also outperforms competing predictors commonly used in the literature”. Essentially what he means by this is that large yield gaps are a reasonable indicator that either bond yields will rise, or that stock yields will fall and visa-versa.

Given that almost no one is predicting that bond yields will magically start rising again, that means that share yields will likely fall; which means that either dividend amounts will fall, or that share prices will rise.

Currently the equity-bond yield gap is at a high 4.9% (compared to an average 2.9% since 2002), which leaves a lot of potential scope for share prices to rise further, so that share yields return to a more “normal” level relative to bond yields.

This means that some institutional and quantitative based investors may still be buying stock at these prices, due to a belief that they’re cheap relative to bonds. However, I don’t personally believe that this fully accounts for the risk of lower dividend amounts, and I also think that the predictive influence of the equity-to-bond yield gap, which was demonstrated by Paulo F. Maio over a decade ago, may start to lose power at near-zero interest rates.

Sam Green is a TradersCircle and Emerald Portfolio adviser. If you would like to talk about an investment portfolio with Sam, please don’t hesitate to contact him on 03 8080 5777 or at sam.green@emeraldportfolio.com.au