Shares versus bank deposits, a modern dilemma for investors, especially in Australia where deposit rates are amongst the highest in the major economies because of our stronger economy and the need for our banks to raise more and more money from small investors and not from overseas credit markets.
And we can’t forget bond yields, although they are a much harder to find investment in Australia for retail investors.
The AMP’s Chief Strategist, Dr Shane Oliver looks at the question.
Shares have had a good rally over the last few weeks as US and Chinese economic data has surprised on the upside.
However, apart from Asian and emerging market shares, most share markets are still well below their April highs and uncertainties about the strength and sustainability of the global economic recovery remain.
But the big question for long term investors is whether shares offer decent long term return prospects compared to alternatives like government bonds or bank deposits?
Price to earnings multiples and the Shiller PE
Shares have had a good rally over the last few weeks as US and Chinese economic data has surprised on the upside.
However, apart from Asian and emerging market shares, most share markets are still well below their April highs and uncertainties about the strength and sustainability of the global economic recovery remain.
But the big question for long term investors is whether shares offer decent long term return prospects compared to alternatives like government bonds or bank deposits?
Price to earnings multiples and the Shiller PE
The simplest way to value shares is to compare share prices to the level of earnings (i.e. the PE).
The chart below for US and Australian shares shows that when consensus 12 month ahead earnings are used, shares aren’t as cheap as they were early last year, but PEs are still below average levels seen over the last 15 years.
Another approach, which is designed to smooth out cyclical swings in the level of earnings, is to use a ten-year trailing average of the level of earnings.
This approach, popularised by Robert Shiller in his book Irrational Exuberance, suggests while US shares are not expensive as was the case at the height of the tech boom, they are not cheap either. (See the next chart.)
The Shiller PE has a long term average of 16 times and currently it is right in line with this, suggesting just average returns going forward.
However, many argue that since the Shiller PE moves around its long term average over time, this would mean it needs to move lower to offset the period where it was well above average over the 1995 to 2007 period, ultimately taking the PE back to the sort of lows reached in 1920, 1932 or 1982.
This would suggest more downside in shares ahead.
The general tendency is for high PEs to precede low returns and vice versa.
However, it is not clear the Shiller PE has to fall to past extreme lows.
Today shares are highly liquid, transaction costs in shares are very low and it is easy to set up a diversified portfolio to reduce overall risk.
This was not the case say 50 or 100 years ago.
As a result it’s likely the fair value line for the Shiller PE may be trending higher over time and as such US shares on this basis are cheap.
The conclusion seems to be that while US shares are not offering the spectacular returns which followed the malaise of the 1970s/early 1980s bear market, the level of the PE is consistent with low positive returns over the decade ahead.
Comparing dividend yields to bond yields
The more important question is to compare the sort of the prospective return from shares to that on other assets.
An obvious alternative is government bonds.
The next chart compares the dividend yield on Australian shares to the 10 year bond yield.
While the gap between the dividend yield grossed up for franking credits and the bond yield is not as extreme as it was during the global financial crisis, it is positive again.
This means shares now provide a slightly higher cash flow than government bonds, with only a modest capital growth required from shares to produce a decent excess return over bonds.
The equity risk premium
A more formal way to compare the prospective return from shares versus bonds is to calculate what is known as the equity risk premium (ERP).
Over very long periods the excess return of shares over bonds has varied.
Over the period since 1900 it has averaged 4.4% pa in the US and 5.9% pa in Australia.
However, the realised ERP over the last 110 years was probably exaggerated by a low starting point for the price to earnings ratio making it easier for shares to produce decent returns.
Our assessment is that the appropriate equity risk premium going forward for developed market equities is somewhere around 3.5% and for Asian and emerging shares is slightly higher at around 4% reflecting their greater volatility.
A simple way to think of the prospective (or likely) ERP for the next 5 to 10 years at any point in time is as follows:
Likely ERP = Dividend Yld plus Growth Rate less Bond Yld
The Growth Rate is the growth rate in share prices and t
