Investment Environment May 2012

04.07.12

After a strong start to 2012 as shown by the S&P500 and JSE ALSI40, the enthusiasm for equities waned considerably in May.

The flight from equities is based on European fears of a Greek exit from the Euro and the contagion effect of the debt crisis causing Spanish banks to fail, which might all culminate in a prolonged recession for Europe. The negative sentiment towards equities was exacerbated by the poor economic news from China and the US.

While Investors take refuge in US treasuries yielding less than 2% largely because of the liquidity and safe haven status that the US government offers, they are ignoring the fundamentals of equity dividend yields. In fact, there has been a paradigm shift in the recent months where dividend yields exceed treasury interest yields which last occurred in the mid 1950’s. This is shown in the graph where the S&P500 dividend yield is compared to a US 10 year treasury interest yield since the beginning of the 20th century. Interestingly the current situation of dividend yields exceeding interest returns persisted for most of the first half of the last century as shown in the graph.

The paradigm indicated above either tells us that equities (current dividend yield 2.08%) are very cheap or treasuries (current interest yrield 1.66%) are very expensive and obviously any combination of these alternatives. Our belief is provided an equity Investor is prepared to take a reasonable term view that the current market weakness should be taken advantage of by at least reaching a full weight allocation of equities according to the mandate of the portfolio.

Fortunately, recent events in June have supported this with China cutting bench mark deposit and lending rates, signalling policy easing supportive of economic growth. Generally central banks (eg The Fed and ECB) remain accommodating and supportive, and as this is written the ECB extend EUR100bn to Spain, facilitating a positive outlook for risk assets. Basically Douglas Investments understand the paradigm is being tested but do not believe that risk assets, such as equities, will provide a higher yield that interest bearing assets for any sustainable period.

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