The coming depression in pictures

One of the annoying things about writing for the print editions of newspapers is that there is never enough space for graphics. The online edition suffers no such constraints, so I’ll air here instead a couple of charts that the desk has kindly drawn up to help me with the column I’m doing on whither the stock market.

Another day, another stomach churning plunge in share prices. Equities look cheap, right, so is it time to buy? Yes indeed they do seem cheap to judge by traditional yardsticks such as price earnings ratios, dividend yields and book value. What is more, relative to bonds, they don’t just look cheap, they look incredibly cheap. The graphic below tracks the yield on the FTSE 100 against the yield on 10 year gilts – the so called “yield gap”.

As can be seen, the traditional relationship, which has ruled with only a small number of aberrations since the late 1950s, is that government bonds yield more than equities. This relationship is underpinned by the idea that over time equities will always deliver a better return than bonds. They are also judged to be a better hedge against inflation. But with the advent of the financial crisis, the relationship has started to show severe signs of strain.

Some time in early 2011, the relationship unambiguously reversed (see second graphic above). When shares are cheap relative to bonds, there’s usually a good reason for it. In a recession, corporate profits suffer, dividends are cut and corporate insolvencies rise. Equities therefore fall. Bonds, by contrast, become the default savings security of choice.

Money that would normally be spent or invested in productive assets gets instead squirrelled away in cash and its nearest equivalent, government bonds. A vicious circle developes, where more cash saving means less demand, equals less spending and employment, equals more cash saving. It’s what John Maynard Keynes dugged “the paradox of thrift” – it’s obviously good for people to save but it’s very bad for demand. Bond yields are driven down to a level which reflects a deflationary environment, where prices fall rather than inflate.

Not good.