Goldman Sachs: Sell bonds, buy shares – 11164

2nd April 2012

Storming first quarter leads to new equity hopes

Equity markets have had a great opening quarter to 2012.  The Standard & Poors 500 put on 12 per cent – its best first three months of any year since 1998 and the seventh best start since 1928; Germany's DAX soared nearly 18 per cent with a similar rise in Tokyo's Topix; the French CAC rallied over 8 per cent; and even the lacklustre and often lagging FTSE100 moved 3.5% ahead.

But US Treasury Bonds had their worst quarter since 2010 with the yield on the 10 year benchmark bond rising 30 basis points (bp equal to 0.3%) while the 30 year bond rose 41bp. In the UK, yields on the the ten year gilt have risen 30 bp – with falls in capital values of some 7 per cent.

Equities set for upside breakout

One quarter does not a shares spring or a fixed interest fiasco make. It was, however, an opportune moment for Goldman Sachs to try to put all that Greg Smith and the Muppets and Vampire Squid stuff behind it and get out there with the most positive buy equity note in years.

The 40 page note "The Long Good Buy: The Case for Equities" states that after 12 years of de-rating,  "The prospects for future returns in equities relative to bonds are as good as they have been in a generation." 

It may not be that rosy

But before looking at their reasoning, their research is bound to provoke critical responses.

·      Goldman might have a long position in equities that it needs to unwind –  as suspicion fostered because trust in investment banks in general and Goldmans in particular is low. This could be a cynical ploy to ensure it can unload client shares in a strong market.

·      The bank is reacting to the first quarter equity market strength – this would suggest that Goldmans hopes that follow through momentum and the strength of  "confirmation bias" – many investors continue to believe that equities must spring out of their 12 year relative to bonds bear market – will ensure buyers for shares and sellers for bonds.

·      Goldman's need for a strong equity market to ensure that the forthcoming IPO of Facebook and others is successful – that way investment banks pick up their underwriting fees intact as well as their other bills. A strong IPO market generates business. And Goldman Sachs is the world's pre-dominant investment bank with a strong equity bias.

·      Ignoring doubts and data contrary to their thesis. This can get technical but some commentators have subjected the research to a line by line search for something they can refute.

·      Forgetting that the world has changed from the second half of the last century – the best ever period for equities. Regulatory change, the ageing population needing the security of bond yields, equity volatility, and the fall in inflation all conspire to ensure the "golden age" for shares is over.

·      The economies of the developed nations have lost their growth; and there are doubts over the emerging markets. Factory output and export orders declined in China over March.

It won't be driven by growth alone

The Goldman Sachs thesis admits that growth alone is unlikely to drive equity markets. Instead, it focuses on valuations, both absolute and relative to bonds, safer ground than trying to forecast economic statistics.

"Given current valuations, we think it's time to say a long good bye to bonds and embrace the long good buy for equities as we expect them to embark on an upward trend over the next few years."

With more than a nod to history, Goldmans likens this moment to that in 1956 when the then Imperial Tobacco pensions fund boss George Ross Goobey urged investing in shares rather than bonds. The "cult of the equity" was born.

Goldmans says that "after a decade of de-rating, equities are implying unrealistically long declines in growth and returns into the future. And while future growth may be lower than experienced over the past decade in many parts of the world, we believe this is reflected in current valuations."

Two decades ago, investors expected a lower yield on equities than on bonds – this "reverse yield gap" paid for the higher long term expectations on shares and. for the certainty that bonds could never return more than their nominal value.

Now we have a equity risk premium – yields are higher than bonds – reversing the past half century or so.  Goldman says: "Future returns in equities are heavily influenced by valuation. The prospects for moderating risk premium raise the probability that equities will embark on a steady upward trajectory over the next few years. The prospects for future returns in equities relative to bonds are as good as they have been in a generation."

At fund managers Schroders, chief economist and strategist Keith Wade says: "There are concerns that 2012 is shaping up to be a repeat of last year when increasing optimism about the world economy is the first quarter had evaporated by the middle of the year, bringing a sharp decline in equity markets. The recent rise in the oil price is an echo of that period and may well herald a period of softer activity.

Differences between this year and last

"However there are some key differences. The commodity shock is not as great as las year as oil prices have not risen as rapidly and food prices are down. Policy makers have acted to support growth.  In the UK, companies will have to increase investment at some stage if only to keep up the maintenance of their existing capital stock.

"In the US, the equity risk premium remains high, equities are undervalued but risk appetite has normalised to halfway between panic and euphoria. Last year, equities and bond yields moved in lock step. Now the correlation has broken down. It may be that equity and bond market investors are at odds with the former believing in a sustained recovery, whilst the latter are more sceptical about growth prospects."

But he cautions:  "Equities may be cheap against bonds but are they cheap enough? Equities are good value against bonds. However, an environment of weaker growth and  more volatility is consistent with a higher premium as investors demand compensation for the more difficult cyclical environment."


More on Mindful Money

Vampire Squids have feelings too!

A toxic relationship: business media, Goldman Sachs reveal bottom line on business morality

Upside down economics – morality before greed

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