Investors have been wary of risky assets. Many are still recovering from the severe losses they experienced in the 'Great Financial Crisis' of 2007/8. The magnitude of those losses drove many investors into low risk asset classes - particularly cash (currently yielding close to zero in most developed markets) and government bonds (at record low yields in many countries). Because the global macro economic environment has been more uncertain than at any other time since the 1930s, investors have struggled to make the move from low risk asset classes into perceived riskier asset classes such as equity.
That has started to change. Investors are waking up to the fact that on a relative basis, stock markets are as cheap as they have ever been. The current spread between the earnings yield of equities and government bonds is 5% (using the US market as a proxy). Simplistically, that implies that even if corporations do not grow their earnings at all, equities are providing 5% per annum more in earnings than bonds are in coupons. To put that differential in perspective, the equity earnings yield has historically averaged less than the bond yield due to the expectation the market usually ascribes to earnings growth.
It is clear, however, that bond yields are artificially low due to the policy of financial repression(2) that the developed world is following in order to correct widespread imbalances. Market participants therefore often argue that it is inappropriate to compare equity yields to artificially low bond yields. This is partly true. What is often missed, though, is that the current level of government bond yields has historically coincided with multiples in the region of 20-25x earnings for the S&P 500, as opposed to the current multiple of 15x earnings. The chart above highlights the intuitive relationship that exists between interest rates and the price earnings multiple of the market. Or, if you invert the argument, bond yields could be 2% to 3% higher and the market would still be reasonably valued on a relative basis. This provides some margin of safety to equity valuations should interest rates rise.
Investors are also beginning to realise that the profligate monetary policies currently being adopted by central banks around the globe may have inflationary consequences. Fixed income asset classes will provide no protection against this. Only real assets such as inflation linked bonds, property, equity (and perhaps gold) can help protect investors in such a scenario.
As investors have slowly re-entered the market, they have favoured the 'lowest risk' risky assets. High yield debt and the equity of defensive, high dividend yielding global franchise businesses have been bid up at the expense of cyclical businesses where the outlook is less certain.
The chart above, provided by RE:CM, shows the extent of the pricing anomaly that now exists between cyclical businesses that are cheap, and defensive companies that are expensive, making them a potentially treacherous investment choice. If the global macro economic backdrop continues to improve in the short term - as it currently seems to be doing - we may see cyclical businesses outperforming. This could provide a further leg up for equity markets.
In the longer term however, the massive structural imbalances that were bothering the market in 2011 and early 2012 still remain. The long-run impact of the current fiscal 'experiment' being conducted by central banks around the globe remains uncertain. Returns today may well end up being 'borrowed' from tomorrow.
 Top and bottom of boxes mark average ratio +/- 1 standard deviation. Whiskers mark 5th and 95th percentile figures. Statistics for all countries and regions are calculated using historical data from 1996 to date for price- to-book value ratio and 2003 - to date for 12m forward price-to-earnings ratio.
 A policy of negative real interests that effectively transfers wealth from savers to debtors