More recursion (or is it embedding?) from the Buttonwood column in The Economist:

THE best bet for the long term is to buy shares and hold on to them. That was the lesson hammered into the heads of investors in the 1990s when the “cult of the equity” was at its peak. Unfortunately, they absorbed the message at precisely the wrong time.

The past decade has been disastrous for equities. Over the ten years to June 18th 2010 investors in developed-market equities earned a cumulative total return of minus 7.9%. By contrast medium-dated Treasury bonds returned 95.3% and high-yield American bonds 102.2%. Richard Cookson, the chief investment officer at Citi Private Bank (and a former journalist at The Economist), points out that the cumulative outperformance of high-yield bonds over equities dates back to 1995.

At first glance this seems rather odd. Bondholders have first claim on the corporate sector’s cashflow and shareholders take what is left. In theory, shareholders should earn the best returns over the long term provided profits keep growing. After slumping in 2008 profits have recently rebounded and, in the case of America, are close to a post-war high as a proportion of GDP. Even if profits had been terrible, owners of high-yield bonds would have suffered too because of a likely jump in corporate defaults.

The answer to the conundrum is valuation. As the cult of equity gained more and more adherents in the 1990s share prices were bid to stratospheric levels. On the best long-term measure, Robert Shiller’s cyclically adjusted price-earnings ratio (which averages profits over ten years), valuations in 1999 were more than a third higher than their previous peak, just before the great crash of 1929. It was a nice irony. Investors bought shares because they desired high returns but their enthusiasm pushed prices to a level from which high returns became impossible.

It’s all a bit Yo Dawg.

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