Really Mean That, Just Because The U.S. 10-Year Treasury Has A 'P/E' Of Less Than 30x, I Should Not Buy The New Safe Haven At Under 20x?

by: Claudio Brocado

The "P/E" of 10-year Treasury notes is > 30x, the way Warren Buffett looks at it, while many US blue chip stocks can still be had for 10 points less!

The pendulum has very quickly swung from fearing the economy is 'too cold' (inverting yield curve) to 'too hot' (soaring interest rates/steepening yield curve). I still see it 'just right'.

Not only relative valuations but investment flows are benefitting US large caps, and the trend should continue.

US blue chip stocks are becoming the new safe haven, and the lagging financials will benefit from several trends, including higher interest rates.

Warren Buffett is known to say that the "P/E" (price to "earnings") ratio of a bond is the inverse of its yield. Thus, even after its recent sell-off, the 10-year US Treasury (10Y UST) note is still trading at over 30 times "earnings" (its coupon payment). With this security, moreover, you have no inflation protection… zero.

I'm old enough to remember when everybody was freaking out about the imminent "inversion" in the US yield curve, which would herald the upcoming recession. Just a couple of weeks later, many of the same pundits are fretting about surging long-term US Treasury yields. If the inverted yield curve didn't, then soaring long-term interest rates are sure to kill the bull market in US blue chip stocks.

This remains the most hated/distrusted US equity bull market in my memory. If the economy is not 'too cold' (pending inverted yield curve), then it's 'too hot' (the Fed will tighten the stock bull market to death)… How about Goldilocks? To me, it is still an economy that seems 'just right' for US stocks to continue to climb the proverbial wall of worry.

Moreover, as I have been writing frequently of late, US blue chip stocks increasingly seem to be the new safe haven. In the aftermath of a 37-year bull market in US Treasury bonds, the market is ripe for a new long-term investment. That is, the outperformance of US large-cap stocks, in my view, is likely to turn out to be much longer than most expect.

Contrary to US Treasury bonds, which face not only the falling demand from QE purchases but also an onslaught of new supply courtesy of the soaring fiscal deficit, US blue chips are arguably as scarce as ever (and repatriation-driven buybacks still have a way to go).

While global deflation rather than inflation has been the main worry since the global financial crisis ten years ago, we are arguably undergoing a reflationary process where inflationary risks cannot be easily dismissed going forward.

Therefore, I believe that one of the risks bond market bulls (and more generally, investors underexposed to blue chip stocks) are underestimating entails their investments not providing sufficient long-term inflation protection. Cash-heavy portfolios are incurring a (perhaps unintended) large risk of purchasing power losses.

As the US Fed continues to hike interest rates in a long process of removing excess monetary accommodation, investors have been fleeing many risk assets, but apparently piling onto US blue chip stocks.

Therefore, I see the outperformance by US equities as a sort of flight to (at the very least, relative) safety. There are arguably no signs of speculative activity, not even regarding US blue chips, let alone financial stocks. This obviously has important implications for discounted cash flow valuation models. While the 'risk-free' rate has undoubtedly increased, the equity risk premium is arguably settling down at long-lasting lower levels.

The risk-free rate (most often represented by the 10Y UST yield) has increased by roughly 90 basis points to almost 3.2% from its long-standing level of around 2.3%. The equity risk premium can offset (and then some) this jump to result in no higher a discount rate for future cash flows.

Separately, while there are undoubtedly many similarities between the lead-up to the US market peak of October 2007 and now, there are, in my opinion, even more differences. I will not address them in this note but suffice it to say that, when it comes to US indebtedness, the public sector is now much more leveraged than in 2007, while the private sector (driven by banks and households) has deleveraged meaningfully. This, in my opinion, reduces the imminent risk of a big debt crisis of the sort Ray Dalio discusses in his book on the topic, which I strongly recommend reading.

I wrote nearly four years ago (please see Tech Bubble? Definitely Not In The Public Markets from December 19, 2014) that I saw no signs of a bubble in US-listed technology stocks. I still do not. Fundamentals remain strong, cash flow generation solid, and valuations are not unreasonable (and in the case of my long-term favorite Apple (AAPL), remain outright attractive). Just as another example of many, Qualcomm (QCOM) is no longer as contrarian a call as just a few months ago, but its dividend yield still exceeds that of the 10Y UST, with growth potential and the ensuing inflation protection.

Please see my Global Asset Allocation Thoughts And Top Stock Picks For 2018 from December 28, 2017, for more US blue chip ideas I like for the long haul. Only JPMorgan (JPM) and Berkshire Hathaway (BRK.A) (BRK.B) made that list among US financials. However, with the higher interest rates and recently-steepening yield curve, I would be more aggressive on this group. I have long liked Goldman Sachs (GS), which I continue to recommend on a long-term basis as well as Morgan Stanley (MS).

Disclosure: I am/we are long AAPL, BRK.B, GS, JPM, MS, QCOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.