If you believe in the future, stick with stocks

Serious Money: After a three-year bull market equities still remain undervalued and the implications of this for investors are obvious; stay fully weighted in stocks.

The mergers and acquisitions boom continues to dominate markets, with very few sectors or even individual stocks immune to deals, real or imagined.

Utilities are all the rage at the moment but plenty of other companies are reckoned to be in the frame for either a friendly merger, hostile takeover from a competitor or unwelcome approach from a private equity company.

If we can guess the next bid targets we stand a chance of being able to get rich very quickly. Are there any clues that point to what happens next?

Is there anything that connects all the deals that are taking place around the world? The answer lies, surprisingly, in the bond market.

Before we get to that bit of the story, let's start with a hypothesis and an investment conclusion. The key idea is that even after a three-year bull market, equities are still undervalued. For investors, the implications are obvious: stay fully weighted in stocks.

How can equities still be cheap? In Britain, particularly, pension funds are getting out of the stock market, partly because they believe stocks to be too expensive but mostly because they think they are too risky. Investing institutions worldwide have been persuaded by people who should really know better that the nature of pension fund liabilities are more like bonds than equities. Hence, those funds should be invested in bonds, not equities. Surely all these smart people can't be wrong? Yes, they can.

Smart investors and actuaries are only part of the story. Clever analysts like Andrew Smithers have been arguing for years that the US stock market, in particular, is still massively overvalued and deserves to fall by at least half. This chorus of bearishness is echoed in publications like the Economist and the Financial Times whose commentators trot out the line that stocks are due for a fall.

It is endlessly fascinating to observe how UK-based commentators are always depressed and their US counterparts always cheerful. Anthropologists go figure!

And if you are not worried about the stock market you should be petrified by what is about to happen to the world economy. Our old friends, global imbalances, just keep getting worse and, despite the fact that they have had no discernable negative impact on anything at all (apart from on the nerves of those of us who have to listen to the doomsters), we are warned that the world is about to end.

At times, members of the economics profession can behave just like Jehovah's Witnesses, with as much sincerity, firmness of jaw and accuracy.

Equities are cheap because bond yields are so low - and are likely to stay low. At this point, sophisticated commentators fall about laughing. It is so 1990s to compare equities with bonds. Post-bubble analysis has it that when we liken equities to bonds we are not comparing like with like (it's a boring debate about real and nominal assets) and, because inappropriate equity/bond stories were told to justify the bubble, we don't do that kind of analysis any more. Cue babies being thrown out with bath water.

Done properly, bonds still matter for equities. In fact, they are really all that matters. The key parameter is the real, or inflation-adjusted (government) bond yield. For all sorts of reasons, this is the benchmark valuation parameter for all asset classes, not just equities. It's not the only driver (see below) but it is at least 50 per cent of the valuation story.

If I can borrow money at, say, 10 per cent it makes sense to do so when I can invest the proceeds and get more than 10 per cent. That's all that banks do, and see how much money they make. Smart investors have worked out how to be banks: there are bundles of opportunities to borrow money and buy companies - whole businesses - that throw off more than enough cash to service the debt and buy the new owners a luxury villa in the south of France. That, essentially, is the story behind modern venture capitalism and private equity. The reasons why individuals can do this are, first, because borrowing costs are low relative to corporate profitability. Second, mainstream investors, those pension funds again, keep selling cheap equities to buy expensive bonds (because they think they are doing asset/liability matching).

This means that the supply of cheap equities to venture capitalists is maintained at a nice steady rate. Throw in all those other guys telling investors that equities are about to crash and there is no shortage of willing punters selling their stocks to smart private equity types. And those private equity guys can borrow very cheaply to fund those purchases.

Low bond yields are partly about a reversion to historic averages (high yields in the 1970s and 1980s have coloured everybody's perceptions of where yields should be), surplus Asian saving and the behaviour of our very smart Anglo Saxon pension funds.

Another important driver of equity valuations is risk. Now, we could talk all day about this but we will keep it brief and assertive. Contrary to what many seem to believe, risk is an awful lot lower than in the past. Put this together with our observations about bonds and we arrive at a very strong (if slightly technical) conclusion: the cost of capital, both equity and debt financed, has collapsed. That explains why equities are still cheap.

Finally, the caveat: this is very much a minority view. Remember, all those smart people are still selling equities. Think about it in a non-technical way: if you are not particularly near retirement and are saving for your pension, what attitude do you have towards the future? If you are fretful and don't think there is going to be much fun to be had then invest in bonds. If you believe in the future, stick with stocks.

In fact, people who tell you to buy bonds because the future is going to be so bad are wrong even if their forecasts are right: if the future is going to be as awful as they expect, don't bother to save for it. Have the fun while you still can. Me? I'm still 100 per cent weighted in stocks.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal