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Thesis: Don't sell, but be prepared to buy aggressively if prices go any lower.

Q: Given the risk of a Treasury default, should the prudent investor sell now and repurchase when it's all over?

A: I say don't sell, but be ready to buy if there is a big sell-off.

The Dow is down 800 points since mid-September, and is now selling for the same price as in May. The forward earnings yield on the S&P 500 is 6.4% and the current dividend yield is 2.1%.

This compares with a Treasury yield curve of:

  • 1-year: 0.10%
  • 5-year: 1.4%
  • 10-year: 2.6%
  • 20-year: 3.4%
  • 30-year: 3.7%

Aswath Damodaran* at NYU estimates the Equity Risk Premium as of Oct. 1st at 5.73%, which is as high as it's been since the Carter years. However, if you look at his calculation of the ratio of the ERP to the risk-free rate, now ~3.2x, it is the highest it has ever been, and six times its historical average of 0.5x.

Clearly stocks are deep in value territory by these yardsticks. It is true that Treasury yields could rise, but it is almost certain that the earnings yield will rise by more, since corporate earnings continue to grow, and companies continue to reduce their float. We are looking today at an historic buying opportunity, similar to the inflationary period of 1977 to 1983, when the Dow was bouncing around 900. If nothing else were to happen except that the ERP/risk-free rate were to normalize at .5x, the Dow today would be 10 times its current level. That is the scale of today's opportunity, at least according to me.

Given that both sides on the Hill appear to be digging in, there is a chance that the risk of a Treasury default could produce a major sell-off, which would make equity valuation all the more compelling. Similarly, there is also the risk of a last-minute deal that could produce a rally. My thinking is that one should hold back just a little longer before taking a plunge, but not too long. I assign a very low probability to a default, so my inclination is to start bargain-hunting soon, before it's too late.

Source: Forget The Debt Ceiling: Stock Prices Are Very Low