It is very easy to lose sight of fundamentals during emotionally charged pull backs like what we saw on Wednesday. Yet it is times like this when stocks go "on sale" that provide investors with the best opportunities, namely to reduce weightings in treasuries and increase weightings in equities
There are many ways to look at the relative attractiveness of equities over treasuries. I will focus on one simple way - the yield differential between equities and treasuries from both an earnings and dividend perspective.
First the earnings yield differential which is simply the inverse of the P/E ratio less the yield of the yield on the US 10yr. In essence it is the return you would get above treasuries if one assumed that all of the earnings generated by the stocks in the S&P 500 were paid out as a dividend. From the chart below you can see that only on three occasions in the last 50 years has the earnings yield differential exceeded 5%. However, this is the longest length of time in which the yield differential has exceeded 5%. This reflects the high degree of uncertainty over the sustainability of future earnings.
Earnings Yield Differential of S&P 500 and US 10yr
Click to enlarge
We can also look at the differential between dividends paid by S&P 500 companies vs. the yield on the US 10yr. It is interesting to note that only once in the last 42 years have equities been cheaper relative to treasuries, and that was during the Global Financial Crisis of 2008/2009!
As the positive dividend yield differential depicted in the graph above suggests, you could borrow money from Uncle Sam right now, let's say $100m, invest it in the S&P500 ETF (NYSEARCA:SPY) or even the Dow (NYSEARCA:DIA) and the dividend you would receive would more than cover the interest you would have to pay out on your loan from Uncle Sam to finance the purchase!
Could this be the trade of a generation? The only way that this trade would come undone would be for earnings/cash-flows to fall significantly. I find little evidence that suggests that earnings are about to collapse (as everyone seems to have been predicting for the last 3 years). Earnings and sales forecasts continue to etch higher and the US economy continues to show every sign of delivering growth that will surprise to the upside over the coming months!
Of course it is somewhat out of most readers' league to borrow directly from Uncle Sam, but there is another way that achieves the same result, shorting the ETF that tracks the 10yr (NYSEARCA:IEF). You can short IEF and with the proceeds invest into the ETF SPY. It is such a simple macro style trade but one in which is likely to outperform most traditional equity funds over the coming years.
I'm using any weakness in this trade to increase my exposure (although I am using the ETF DIA instead of SPY). I'm walking the talk and not being caught up in the fear of Mr Market's volatility headlights!
Disclosure: I am long DIA.