Comparing equity yields with term deposits is lazy
I have been getting a little bit irritated by the constant comparisons between the yield on equities and the yield on a bond or term deposit.
I have been getting a little bit irritated by the constant comparisons between the yield on equities and the yield on a bond or term deposit.The argument goes that equity yields are now higher than bond yields and also higher than term deposits, so you should switch.But the truth is that a comparison of the returns on term deposits or bonds with equity yields is simply lazy and ridiculous and reckless, because it misses the point about why people are in term deposits in the first place.Let me explain by taking a well-known income stock the National Australia Bank, one of the highest-yielding and safest blue-chip stocks in the market. The yield on the NAB is 7.5 per cent - 10.7 per cent including franking. That, everyone will tell you, is cheap and the argument is that all you mugs holding term deposits earning just 5.5 per cent are idiots because you get a whole extra 2.2 per cent in the NAB or 5.2 per cent including franking.Fair enough, until you consider this exercise.Get a chart up of the NAB over the last year (one year will do). Now mark off the peaks and troughs since January and calculate how many and how big the variations have been. You will find that the NAB has had 10 fluctuations. Five rallies and five falls.The size of the rallies has been 12.8 per cent, 17.8 per cent, 8.3 per cent, 23.2 per cent and 26.9 per cent. The falls have been -9.8 per cent, -15.3 per cent, -23.9 per cent, -13.5 per cent and -18.7 per cent and if we picked a smaller-income stock or took NAB out over a longer period, it would be even more dramatic.Now tell me after 10 moves of more than 7.5 per cent in just a year that I should be worrying about the 7.5 per cent yield on the NAB. Now tell me, amid that volatility and instability, that I should mention the yield on the NAB and the yield on a risk-free term deposit or bond in the same breath. Now tell me the prudence behind selling my term deposit and buying the NAB.The NAB and almost all other income stocks in the current market, are not stable low-risk investments they are volatile trading stocks and the message is clear and let's make it clearer, once and for all. You cannot compare the yield on an equity to the yield on a bond because one includes no risk of a capital loss (no risk of a gain either) and the other contains a currently huge perceived risk of a capital loss (or gain).Promoting income stocks because they yield more than a bond is ignoring that extra risk and misunderstanding why people are now in bonds and term deposits. They are there because they don't want to lose any more money. Because they don't want volatility.The only way to compare equities to bonds or equities to term deposits is if the equities came with a price guarantee, which they don't, or if you compare risk-free yields with the expected total return from equities, which includes the extra volatility and risk and not just the dividends.In the current market, equities are nothing like a bond or term deposit because share-price risk is dominating the investment decision not the yield. Do you really think people are in term deposits to make 5.5 per cent? No, they are in term deposits to avoid losing money. The focus is on the risk not the return. Risk rules.But it's not all gloom. The good news is that this is not a normal state of affairs. The sharemarket is supposed to be about opportunity not risk and the fact that risk is so in focus means the opportunity side of the equation is being ignored.Also, risk can change very quickly. Ahead of the last European Union summit the market jumped 11 per cent in four days on lower perceived equity risk. The banks jumped 19.2 per cent. If the GFC doesn't reignite, the focus is going to very rapidly swing back to yields and price-to-earnings (PE) ratios. If the GFC is behind us, how long do you think the NAB is going to trade on a 10.7 per cent yield and the market on a PE of 10.7 times against a long-term average of 14 times?Not long. In which case the game now is not debating the marginal merits of term deposits versus equities but waiting for a chink of light in the outlook for risk, because that is all that matters and because when it appears, the herd is going to smash down the door to get to those yields and PEs.At the moment they don't believe in them. Your job is to be on the ball on the day they do.Marcus Padley is a stockbroker with Patersons Securities and the author of sharemarket newsletter Marcus Today. His views do not necessarily reflect those of Patersons.