If one good term deserves another, many happy returns

I HAVE been getting a little bit irritated by the constant comparisons between the yield on equities and the yield on a bond or a 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 a term deposit.

The argument goes that equity yields are now higher than bond yields and 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 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, National Australia Bank, one of the highest-yielding and safest blue-chip stocks in the market. The yield on NAB is 7.5 per cent, or 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 an extra 2.2 per cent in NAB, or 5.2 per cent, including franking.

Fair enough, until you consider this. Get a chart up of NAB over the past 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 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. 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 NAB. Now tell me, amid that volatility and instability, that I should mention the yield on 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 NAB.

NAB, and almost all other income stocks in the 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 with 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. The only way to compare equities with bonds or equities with term deposits is if the equities came with a price guarantee, which they don't, or if you compared risk-free yields with the expected total return from equities, which includes the extra volatility and risk 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.

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. Plus, risk can change quickly. Before 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 global financial crisis does not happen, the focus is going rapidly to swing back to yields and price-earnings ratios.

If the GFC was behind us, how long do you think NAB is going to trade on a 10.7 per cent yield and the market on a P/E of 10.7 times against a long-term average of 14 times (25 per cent below average)?

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. When it appears, the herd is going to smash down the door to get to those yields and P/Es. At the moment, understandably, they don't believe them. Your job is to be on the ball on the day that they do.

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