There comes a time when every investor asks themselves "Should I be in equities or in cash?" For PowerStocks subscribers this is an easy question to answer, since the SUPERModel and Long-Bond Yield Curve investment timing models have clear, unambiguous quantitative answers based on their signal lines which tell us if the JSE is safe or not.

However, even when we have the "all clear" for the stock market, we rarely sit 100% in equities. As described in "The PowerStocks Way", we phase our cash into the stock market as our investment timing models' signals get more and more bullish and we phase out equities as they get weaker. In addition to this phasing in and out of equities as a percentage of your portfolio it is always prudent to diversify your investments among different asset classes. If you are carrying a large amount of investment and have a more risk averse style of investing, it is highly advisable that you split your investments between cash, bonds, property and equity to offer proper diversification of your overall portfolio. Additionally, there are periods when our investment timing models say it is safe to be in the JSE but even so, being overweight bonds in the portfolio may offer better risk adjusted returns.

Whilst we are busy with another research topic on optimal diversification strategies inclusive of equity, bonds, property and cash etc. this research note focuses specifically on the question of when is the best time to be overweight bonds and the best time to be overweight equities, assuming you were just mixing bonds and equities in your portfolio.

In his excellent book (one of our favourites), "The Effective Investor" by Franco Busetti, it is shown that there is a strong correlation since 1970 between yields on SA bonds and JSE equities versus their respective subsequent 5-year returns. Note that "earnings yield" is merely the inverse of the P/E ratio.

Whilst this confirms that low yields correspond to higher future returns and corroborates our more recent research on ALSH P/E's and subsequent 12-month returns, it doesn't help us answer the question of how to determine when is it best to buy bonds versus equities and vice versa.

We cannot simply directly compare bond yields to dividend yields to make a decision. Future inflation and dividend growth need to be taken into account. For the most part, bond yields are greater than dividend yields since equity investors also take dividend growth into account when evaluating equity yields. Bonds however have fixed interest and thus the yield remains constant once purchased. So higher dividend flow over time can justify lower yields relative to bonds. Also high inflation can eat away at the fixed yield you obtain from your bonds whilst earnings yields will typically rise in tandem with inflation.

Since it has been shown that the yield on bonds and equities is a strong determinant of future returns, then the relative yield of these two asset classes should provide a good indication of their relative future returns, which will then answer our question which is the best asset class at any point in time. The chart below, also taken from Franco's book shows that this is indeed the case:

In this case he used the ALEX (Financials and Industrials) index to remove the bias effect of the resources shares in the ALSH index to compare the yield on the all-bond Index (ALBI), less inflation, to the  ALEX earnings yield to derive a "real yield ratio" and then plotted subsequent 3-year returns based on all the observed ratios since 1970.

Franco's regression chart above provides us with some definitive decision metrics. When the relative yield ratio is 0.6 and below its statistically better to buy equities (or be overweight equities). When the ratio is 1.4 and above its better to buy bonds (or be overweight bonds). At PowerStocks we will now be tracking the relative yield ratio as shown on the below diagram:

We have taken the liberty of a more granular interpretation of the thresholds, based on Franco's regression chart to define 4 areas where (1) Equities ALWAYS have historically out-performed, (2) Equities have MOSTLY outperformed, (3) Bonds have MOSTLY outperformed and (4) Bonds have ALWAYS out-performed.

So we now have a charted ratio that can help us decide when we should be over or underweight equities or bonds, to assist us with our asset class diversification strategies. We strongly advise that subscribers use the above plotted ratio IN ADDITION to our SUPERModel and LBYC investment timing signals for optimum results.

For example, after June 2007, the ALEX started its final peaking process before the great crash (note that ALEX peaked 1 year before the ALSH due to the ALSH being bolstered by resource counters.) Around this time, the relative yield ratio between bonds and equities was below 0.6, telling us that "Equities always outperform!" Now anyone who invested around this time in the JSE would really have taken a beating, but not if they looked at SUPERModel and LBYC, since they both would have been telling us to stay the hell clear of the equities market!

We can thus come up with the following rules:

1. When the SUPERModel and/or LBYC models tell us its unsafe to be in the JSE, go 100% bonds
2. Otherwise use the relative bond/equity yield ratio as follows:
    - less than 0.6 - go overweight equities (90%-100% of assets for example)
    - between 0.6 and 1 - trim equities (70%-80% of assets for example)
    - between 1 and 1.4 - underweight equities (30%-40% of assets)
    - over 1.4 - overweight bonds (90%-100% of assets)

You can get exposure to bonds through an easy to buy ZShares Govi ETF which is listed as a standard share on the JSE you can purchase through your online broker just like SATRIX-40. It tracks the All-Bond Index (ALBI) and means you can tap into the bond market without going through a complex purchase process through the bond exchange. The website has a description on this ETF over here.

The Relative Bond/Equity Yield Ratio will be published once per week in the Weekly JSE Pulse (WJP) for both STANDARD and PRO subscribers as shown below:

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