Markets need a history lesson

So says, err, Citi.

50 years of financial orthodoxy is being questioned. Assets are being priced back to the 1930s. Does this reflect the end of modern financial theory?

That’s the bank’s pan-European team in a recent note. The central argument seems to be that the market is ignoring 50 years of financial history in the way it’s pricing assets like cash, equities, etc. today. For instance, by Citi’s calculations, long-run capital returns from owning European and/or UK equity have fallen from about 7 per cent in 2006-07 to 4 per cent today. The average between 1919 and now was 5 per cent — so we’re still below the average. Why the change?

As the financial crisis has evolved, risk has been aggressively re-priced. Corporate bond spreads have gapped out. Equities have been violently derated. Cash and government bonds have outperformed. Fear has beaten greed. Capital preservation has beaten capital return… The attraction of cash in absolute yield terms has fallen materially, and should continue to fall. By contrast, yields on risk assets, such as equities and corporate bonds, appear to offer investors rare attraction.

The below chart shows how many standard deviations certain asset classes are trading away from 10-year average levels (on a yield basis). In otherwords, when yields are trading above 10-year averages, this implies more attractive yields on offer to longer-term investors according to Citi, and vice-versa. So is Citi saying it’s time to forsake the safe-haven of things like cash for say, equities?

Not quite. Instead they’re arguing investors think twice before selling stuff like equities to enter cash:

Comparing current yields to 10-year average levels: equities have never looked so cheap, cash has never looked so expensive. This does not mean that share prices have hit their lows for this cycle. Indeed, the prospect of further forced selling and big earnings decreases pose significant hurdles. But, we believe long-term investors and asset allocators should think hard before selling beaten-up risk assets in favour of risk-free assets from here.