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Registered investment advisor, closed-end funds, contrarian, CFA
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Equity markets advance by climbing a “wall of worry." There is no shortage of worry. However, sometimes the numbers and the investment reasoning line up so neatly that it’s hard to logically refute the investment implications. And while pundits will “over-think” the issues (so they have something to say on outlets like CNBC, the Sesame Street of financial news), some of it will be interesting -- but most of it will be noise.

Stock Drivers: What ultimately drives stock prices are earnings prospects and relative returns (valuations). There is a strong case for equities on both these counts.

Earnings Growth: As it relates to earnings prospects, the S&P 500 earnings are estimated to be up almost 50% in 2010 over a very depressed 2009. In 2011, earnings are projected to advance another 13%. So if these estimates are reliable -- an always important assumption -- we have the potential underpinning for equities advancing based on this fact alone, assuming reasonable historical multiples.

Relative Returns: The average spread between the S&P 500 equity yield and the 10 Year Treasuries since 1987 has been -0.17%. Currently, this spread is 3.37%. It is the highest spread during the period and well outside of the range of the recent historical average.

Visual Confirmation: Below is a simple chart [click to enlarge] of the year-end equity yields of the S&P 500, based on estimates for both 2010 and 2011 provided by Reuters Thompson, versus the 10 year Treasury yields since the trough of the S&P 500 index in 1987.

Valuation: The historical S&P EPS multiple on trailing EPS is 15.4 times since 1943. If the 2011 S&P 500 estimate of $95.00 per share is achievable, then the current S&P 500 valuation is 1,463 at year-end 2011, or up approximately 16%. (See an earlier post here.)

Supporting Cast: The other items that lend encouragement to this assessment are that the economy is showing signs of recovery, and that there is some evidence that investors are moving out of bonds into equities, based on some of the recent long-term mutual fund flows. Either a growing economy or the flooding of paper currency into the global financial markets will have inflationary implications and prompt interest rates to rise.

Recommendations: I think any of the large-cap ETFs are a logical candidate for share price appreciation in 2011. This would include SPDR S&P 500 (NYSEARCA:SPY) or its dividend equivalent SPDR S&P Dividend ETF (NYSEARCA:SDY) for some downside protection.

Augmenting this investment scenario would be to go “short” treasuries. One way to accomplish this while limiting the risk would be to buy inverse long-term treasury ETFs like ProShares 20+ Year Treasury ETF (NYSEARCA:TBF). This way an investor would benefit from the rise in equities and the decline in fixed income. (I would only recommend this latter strategy to investors willing to accept a high level of risk.)

Caveats: The risks include the usual suspects: Sovereign debt crises, global commodity inflation, bond market meltdown, rising U.S. deficits and debt to GDP ratio, China’s economic slowdown, over-optimistic analysts, housing collapse, etc. These are all the bricks in the “wall of worry.” Most of these concerns appear to be “priced” into the equity markets.

What typically takes markets down is not what you’re currently worrying about; it’s the events you can’t predict like war, terrorism or natural catastrophes. This is why investing can never be a science, due to the randomness of events impacting the markets. This is why I highly value liquidity — particularly as we enter this phase of the investment cycle.

Wishing you successful investing in 2011!

Disclosure: Long SPY, SDY, TBF.