EQUITIES are triumphant again. Analysis by Jonathan Stubbs at Citigroup shows that American and British shares have outperformed government bonds over the past one, two, three, five, ten, 20 and 25 years. That follows a dismal period when, thanks to two bear markets in the first decade of this century, equities looked like long-term losers (see chart).

In a healthy economy you would expect equities to produce a superior return to bonds over the long run. If an investor buys a government bond and holds it until maturity, the nominal return is fixed. The return from equities is driven by the level of corporate profits. On the assumption that their proportion of GDP is stable over the long run, profits should rise in line with the economy, driving nominal returns up.

Furthermore, equities are riskier than government bonds, in the sense of being more volatile over the short term. You would therefore expect investors to demand a higher return (the “equity risk premium”) in exchange for taking the extra risk of holding them.

Ironically, the belief that higher equity returns are inevitable may have led to the period of bond outperformance. Investors’ enthusiasm for equities pushed stockmarket valuations into the stratosphere. When valuations then fell back to more normal levels, the performance of equities suffered. The bigger the overvaluation, the bigger the effect on subsequent equity performance. In Japan, following a huge equity bubble that popped in the early 1990s, the 20-year return from shares is minus 9%, compared with a 117% gain from Japanese government bonds.

The poor performance of equities in the first decade of this century has reinforced a tendency on the part of big institutional investors to reduce their exposure to stocks for other reasons. Regulatory changes have encouraged insurance companies to put less of their money into equities than they did 20 years ago. Corporate pension funds have also moved out of equities, particularly in Europe, in order to focus more on owning assets that resemble their liabilities. (A pension, the requirement to pay a steady income over a prolonged period, is a bond-like liability.)

Endowments, which have a more robust risk appetite, have also edged away from the stockmarket in favour of “alternative assets”, a broad-brush category that includes things like hedge funds and private equity. These long-term trends are unlikely to be subject to dramatic reversals.

Mr Stubbs describes these investors as “undynamic asset allocators, but there are plenty of dynamic ones. Studies find that mutual-fund investors pay a lot of attention to past returns when allocating assets*. The improved long-term performance of shares may encourage more flows into these funds. According to EPFR Global, a data provider, investors have pushed more than $200 billion into equity funds this year, helping the stockmarket to do even better.

Sovereign-wealth funds may also be keen to devote more money to equities. Some of these funds were chastened by stockmarket losses in 2007 and 2008, not least because they copped heavy criticism for losing chunks of the nation’s wealth. But the steady gains achieved by developed-country equity markets in recent years now look rather tempting, especially compared with the meagre yields available in the bond markets.

Improved risk appetite may also encourage more bid activity, both within the corporate sector and from private-equity groups. When their firms’ share prices go up, chief executives often feel tempted to go on a spending spree. More than $500 billion of mergers and acquisitions have already been announced this quarter, according to Bloomberg.

So does this mean equity markets are getting bubbly? Not yet. American shares look overvalued on long-term measures such as the cyclically adjusted price-earnings ratio but the same cannot be said for Europe. Emerging markets, often the subject of speculative frenzy, are depressed. Retail investors may be recovering their appetite for equities but they are hardly gung-ho. Few people are giving up their jobs to become day traders.

What seems to be happening is that flows in the financial markets are returning to normal (in the historical sense), even though the global economy has yet to pull off the same trick. The big test is whether such confidence on the part of investors is justified.