Will Bond and Stock Prices Ever Converge?

I feel I've been having this conversation for over a year now: are bonds too cheap, or are stocks too expensive? Yves Smith points out today that the FT is on the case, with John Authers taking the view that the two are bound to converge soon, and John Dizard taking the opposite case that the disparity is likely to stick around for a while.

Part of the problem is that low prices in the fixed-income market are increasingly reflecting illiquidity rather than low fundamental values. Dizard notes that this has implications for regulatory regimes which are "based on the notion that markets are liquid, continuous, and efficient":

Right now, there is a sotto voce argument in the policy world over the social utility of marking assets to market when, really, there is no market. The effect of mark to market, embodied in America in the form of FAS 157, the accounting standard, is to decapitalise the system more rapidly than new capital can be raised.

(Case in point: AIG.)

Another reason for the disconnect is that the markets have inherent differences when it comes to valuing the future. Andew Clavell, as is his wont, puts it in terms of calls and puts:

Credit instruments (corporate bonds) are essentially risk free bonds with embedded short put options on this pretax corporate cashflow. Equities are call options on after tax corporate cashflow, struck at the present value of the credit instruments.

What this means in English is that when the markets start to anticipate a future recession, bonds fall long before stocks do. Only when a recession starts to actually hit corporate profits are equity prices likely to follow suit.