Best Available Risk Reward Proposition

Asset allocation has been a vexing issue for investors recently.

Because of our expansionary monetary policy (low interest rates, printing money) and stimulative fiscal policy (unprecedented budget deficits), inflation is inevitable. Fixed income is not the place to be during inflationary cycles because bonds are pulverized under the pressures of inflation, as does the purchasing power of their coupon payments. As an asset class, bonds are currently misunderstood and mispriced, with more risk than appears at first glance.

What about real estate? At the end of the first quarter of 2009, about 27% of all outstanding mortgages in the US had negative equity, and that number may double before the housing market stabilizes. Some experts expect half of commercial real estate loans to be in default by next year (compared to a historical average of just 4%). Moreover, they expect severity of losses to be 40%, vs. a historical loss severity of just 10%. Those numbers are truly staggering.

People are now “strategically” defaulting even if they still have a job, as they lost hope of recouping the purchase price of their home, and can now rent a similar house at a price lower than their mortgage payment.

In addition, most banks do not have enough reserves to cover their losses from real estate still on their books. If they took the appropriate marks on their loan books, they would probably be insolvent.

This will be a different kind of inflationary cycle. The dollar will decline, but Real estate prices will not be going up because few property owners can raise rents right now.

In contrast, the spread between stocks and bonds prices is the widest it has been in four decades.

Since stocks and bonds are always in competition for investors’ money, it makes sense to monitor the relationship between bond yields and stocks’ earning yield (the inverse of a P/E). That relationship has a major impact on equity prices. When you can buy a stock with an earning yield equivalent to that of a similar credit quality bond, the stock is more appealing because it gives you both the earnings yield and the growth of earnings over time, whereas a bond has interest payments that are fixed and aren’t even protected against the eroding power of inflation.

Even after this year’s rally, many stocks are still reasonably priced. Warren Buffett says if you buy stocks when the total market value of US stocks is 75% of the GDP, you are likely to do well over time. We are there now, and there are unique, high quality opportunities selling at bargain prices.

For example, Wal-Mart’s (WMT) earning yield is 7%. Add their 2% growth rate, and you have a 9% “coupon”, plus inflation (Wal-Mart raises prices in line with inflation). Compare that to the 4.5% coupon on US government bonds, or even to the average corporate bond yield of 6.17%, which are without inflation protection, and Wal-Mart seems very attractive.

Wal-Mart is currently down 7.5% for the year. Other large cap stocks present a similar opportunity, as this year’s rally skipped them. Johnson and Johnson (JNJ) is flat for the year. Berkshire Hathaway (BRK.A) is up less than 5%, and all three are unlevered, well managed and very reasonably priced. This is the best risk/reward proposition available to investors right now.

The stock market has a history of appreciating 31% on average in the year following a bear market bottom. I obviously don’t know what the indices are going to do in the short run. But I happen to think that the panic selling crescendo in March 2009 was a generational bottom for stocks. We will not go back there even if the economy double dips.

March 2009 may be analogous to 1942, when the market averages bottomed and started a rally that lasted a full generation. At the 1942 bottom, the Dow was at 100. In the late 1960s, it was at 1,000.

Disclosure: Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Wellcap is long WMT, JNJ and BRK.

Comments

[Living4Divi...:]

Terrific article !

I agree that fixed income will be devasted by the coming inflation. Additionally, yields are at or near multi-decades lows. When yields rise and inflation rises, bonds will be hit with a double whammy.

Investors tend to think of bonds as a "safe and boring asset." The above paragraph shows that bonds are risky. Cash is slightly safer, because cash has no duration. Even so, cash is subject to the effects of inflation.

Risk is defined by the academics as standard deviation of returns (volatility). OK, volatility is to be avoided, but it is not the only thing to be avoided.

The best definition of RISK is "Loss of purchasing power."

Oct 20 08:02 AM

[chap08:]

Good piece. The stock market as a whole is starting to look unattractive, but there are still some acceptable valuations - some of which have been largely ignored in the rally. I hold a lot of international stocks but these are starting to look expensive too.

A year ago I saw gold as the best risk reward. I will ride that pony a bit longer, but after a 50% rise, it is difficult to justify any more buying.

When everything starts to look over valued, I hold more cash. Yes there are inflation risks but there's a good chance that something will get a lot cheaper at some time - perhaps some time soon.

Oct 20 08:54 AM

[cd:]

I agree with alan's bond ideas and like chap08's thoughts on holding cash, but "some time soon" is very important.

Oct 20 09:24 AM

[David Braun...:]

I really don't buy the inflation theory. Even with the stimulus, the CPI is running a deflation of 2.2%. What happens as stimulus is withdrawn? How do you reconcile declining real estate prices with inflation? I agree that there is risk in long-term bonds as the economy may come back one day, but that day is not soon. In the meantime, I would be looking to buy long term bonds after the Fed stops its quantitative easing program. Then we will see the true rate of deflation surface.

Oct 20 01:06 PM

[user396040:]

I think that the FED will keep interest rates low until either of one of two scenarios appears on the horizon - reduced unemployment or inflation. I think they are both a ways off. In this environment, blue chip dividend paying stocks are hard to beat.

Oct 23 12:54 PM