The reverse yield gap and the long bond/nominal GDP growth dynamic

Bond yields used to be lower than equity yields, and significantly so, up to the 1950s. The reversal of this relationship during the late 1950s, a reversal which peaked at the end of the 1990s, helped provide a significant revaluation of equities during this period.  Many a long term equity return expectation has been built upon the reversal of the original yield relationship.

The following charts use US data sourced from the Shiller/Yale dataset to highlight this input to historic equity returns and risk premium.

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And of course, the same goes for the more pronounced earnings yield relationship (Shiller/Yale source data): note the earnings yield/ten year bond yield ratio:

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Yes, we have experienced a move back in bond yields below those of equity earnings and dividend yields, but this has been mostly brought about by a sharp fall in bond yields to historically low levels, rather than a more pronounced change in equity valuations.  

But before we get carried away with a belief that current valuations are historically attractive, we need to remember that a large part of the recent increase in the earnings yield relative to bond yields is also due to exceptionally high cyclical profit margins.

After adjusting for cyclical earnings and extremely low bond yields, the actual yield relative is closer to that noted in the following graph: that is we move from once in a lifetime value (shown in the above chart), to close to the lower bound of limited valuation.

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Moreover, we can look at the 10 year treasury yield relationship in the context of nominal GDP growth, another key factor in determining return expectations.   If we look at longer term relationships we find that other periods of similarly low bond yields were characterised by much higher nominal GDP growth: we are operating within a different paradigm.

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GDP data is sourced from the BEA: the green line in the above graph shows discrete annual nominal GDP growth, while the blue line the geometric average over a rolling 5 year period.

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