Have you heard the one about the taxi driver who never bothers to stop at red traffic lights? No? Well here goes. In a small town, many miles away from our law-abiding Singapore, a taxi driver one day picked up an out-of-towner. The passenger climbed into the taxi and asked to be taken to the railway station. Crash course Everything seemed to be going swimmingly until the passenger discovered to his horror that the driver would barrel through red lights without a care in the world. On several occasions he missed colliding with other cars by just the thickness of…
Have you heard the one about the taxi driver who never bothers to stop at red traffic lights?
No? Well here goes.
In a small town, many miles away from our law-abiding Singapore, a taxi driver one day picked up an out-of-towner. The passenger climbed into the taxi and asked to be taken to the railway station.
Everything seemed to be going swimmingly until the passenger discovered to his horror that the driver would barrel through red lights without a care in the world. On several occasions he missed colliding with other cars by just the thickness of a coat of paint.
After shooting through several red lights, the now totally-petrified passenger asked the driver if he was stark-raving mad to jump red lights. The driver said none of his taxi cohorts stopped at red lights. So why should he?
Gripped by fear, the passenger relaxed a little when saw in the distance a set of green lights. As the driver approached within inches of the lights, he slammed on his brakes, sending anything that was not nailed down, screwed down or glued down hurtling into the dashboard.
The passenger screamed at the driver and asked him if he was totally insane to stop on green. The driver grinned and said: “You can never be too careful. You never know when one of my fellow drivers might be coming through”.
The story could almost be amusing, if it wasn’t also a reflection of the way that we sometimes invest.
How often have you seen people pile into overpriced assets simply because other people are buying? It is really no different to the driver charging through a set of red traffic lights just because his cohorts do it too.
What is even odder is that when asset prices are flashing green, we slam on our brakes. This kind of irrational behaviour is happening right now. Yes, it is.
Currently, investors are piling into bonds with gay abandon, even though they are flashing red. It seems that some investors are willing to pay almost $102 for 10-year US Treasury Bonds that yields just 2.3%.
Meanwhile, our Singapore market, say, is currently valued at just 13.5 times earnings. Put another way, if all the profits made by our Singapore companies are paid out as dividends, the theoretically yield could be 7.4%. In other words, the earnings yield is much higher than the yield on a risk-free asset such as the 10-year US Treasury.
Pay me more
Naturally, we should expect to be paid a premium for buying shares over bonds. That just stands to reason. But is it realistic to expect the premium to be as much as 5.1%? We are, after all, talking about blue chips such as SingTel (SGX: Z74), DBS Group (SGX: D05) and Jardine Matheson (SGX: J36).
To my mind, the premium should, if anything, be closer to zero. If you think about for a moment, it is easy to see why.
Companies tend to increase their earnings whereas the yield on a bond you buy now is fixed. Consequently, the earnings yield takes into account future earnings growth. But even if we ignore earnings growth completely, the premium for owning equities still looks attractive.
There is something else to consider too, namely the reasons why the US Federal Reserve is considering removing monetary stimulus. Firstly, it cannot continue magicking money out of thin air. Secondly, the Fed believes that the US economy is approaching the moment when it can start to grow unaided.
How to lose money
If the US economy does improve, it could be welcome news for many companies around the world, especially for those that are sensitive to economic change. Thinking about the 30 companies that make up our Straits Times Index (SGX: ^STI), I can pick out 20 that could benefit from the improvement.
If stimulus is removed, it should not be seen as a signal to ditch equities in favour of bonds. We should, in fact, be seriously thinking about doing the exact opposite. Or as Warren Buffett once pointed out: “Some investors could lose a lot of money in long-term fixed-income assets when interest rates eventually start to rise”.
I certainly don’t want to be one of those.
To me, the signs for equities look a favourable green, while the signs for bonds are flashing crimson red. That could indicate a “go” for stocks and a “stop” for bonds. That is unless you are someone who stops at green traffic lights and goes on red.
A version of this article first appeared in Take Stock Singapore. If you would like Take Stock Singapore delivered directly into your inbox every week just Click here now. It's FREE.
Written by David Kuo, Take Stock - Singapore tells you exactly what is happening in today's markets, and shows how you can GROW your wealth in the years ahead. Like us on Facebook to keep up to date with our latest news and articles. The Motley Fool's purpose is to help the world invest, better.
The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo doesn’t own shares in any companies mentioned.