Investors invest in equities at a time when the yield gap is negative because they expect:

• A. Inflation to fall.
• B. Dividends to increase in the future.
• C. Equities to fall sharply in value in the near future.
• D. Bond yields to rise.

Answer: (B)

When the yield gap between equities and bonds is negative, investors are betting on stronger future cash flows from stocks rather than relying on the current income alone. The main idea is that total return from stocks comes from both dividend income and capital gains as the market prices in expected growth.

If investors expect dividends to rise in the future, the stream of cash flows from owning equities should grow over time. Even though the current dividend yield might be modest relative to bond yields (giving a negative yield gap today), the anticipated growth in dividends means the overall return from stocks could improve enough to outperform bonds later. In other words, higher future dividends make equities attractive despite present sentiment.

Why the other options don’t fit as the best explanation: a belief that inflation will fall doesn’t directly explain why investors would prefer equities when the current yield gap is negative.Expecting equities to fall sharply would reduce, not increase, the appeal of holding stocks. Anticipating bond yields to rise would generally change relative attractiveness, but it doesn’t explain the motivation to invest in equities specifically today; the decisive factor is the expected growth of the dividend stream, which would lift future returns.