The Most Dangerous Investment

July 25th, 2010
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Contributed by: James Berman, JBGlobal
A United States Treasury Bond is now the most expensive, most dangerous investment asset in the world -- while blue chip equities, especially American and European Multinational stocks are as cheap as they've ever been.

One model of valuation is the so-called "Fed Model," historically used by Fed analysts to measure the relative value of stocks vs. bonds. This compares the yield on the 10-yr Treasury to the earnings yield of the S&P 500.

At points of equilibrium, the yield on the Treasury bond should roughly equal the earnings yield. The future return of a stock should comprise its earnings yield plus an inflation adjustment plus a growth adjustment, while a bond will only deliver the coupon interest rate (if trading at par value). The additional components to stock return compensate for the higher risk. And so if the earnings yield equals the treasury yield, a risk-reward equilibrium exists.

Right now the earnings yield on the S&P 500 is 7.81% (the inverse of a 12.8 forward p/e ratio) while the 10-yr Treasury yields 3.08%. The stock market yield is more than double the Treasury. This is a historically vast divide.

This implies that the future ten year return on equities should be something north of 7.81%, while that of bonds only 3%.

In European stocks, the divide is even starker. In the ADRU, which we own for clients, the basket of underlying stocks has an 8.3% earnings yield, implying a double digit return when inflation and growth adjustments are added in.

In short, obligations of the U.S. government do not provide nearly enough compensation for the underlying credit risk (regardless of inflation expectations), while cash-rich companies provide a good risk-reward profile for those with time horizons of three or more years.
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