Where Is Investment Value: Stocks Or Bonds?

Includes: DIA, IEF, SPY
by: Jason Tillberg

I read a lot of commentary and research from other investment advisors and research analysts. Over time I have built up a list of folks whose research I both value and tend to agree with.

For stock market valuation, I have found the research of Adam Butler and Mike Philbrick of Butler\Philbrick & Associates at Macquire Private Wealth in Toronto, Canada, to be not only thorough, but in line with my way of thinking about investing from both a long term and value investing standpoint.

They look at 4 components of market valuation.

1. Q Ratio

2. Total Market Capitalization to GNP

3. Deviations from Long Term Price Trends

4. Shiller P/E

The Q Ratio measures how expensive stocks are relative to the replacement cost of total corporate assets. I like to ask myself the question, if I had enough money to buy the entire business at the current market price, would I want to do it or would I be better off using the same amount of money and starting a new company for perhaps substantially less money.

The Total Market Capitalization to GNP accounts for the proportion of the value of all the publicly traded companies relative to the size of the economy.

Deviations from long term price trends tell us how stretched prices are from long term averages. Like pulling a rubber band either up or down.

The Shiller P/E takes the 10 year corporate earnings average to account for typical business cycles and gives an adjusted earnings yield.

Combining these metrics, they have found that their model works best over a 15 year period in predicting inflation adjusted returns.

Here is a chart put together by Doug Short that shows their past model predictions and actual inflation adjusted investment returns.

(Click to enlarge)

Their model has been for the most part, quite accurate as the blue line (actual inflation adjusted returns) has tracked the models predicted annual rates of return (the red line).

There are some conclusions that can be drawn from this chart. First, the markets valuation since the early 1990's has been at a valuation that has been modeled to provide long term investors will below average rates of return.

From 1997 - about 2002, the markets valuation was such that the expected rates of return were modeled to be negative inflation adjusted over the following 15 years.

If you were lucky to buy the market on March 9th, 2009, at the bottom, you could have captured the market at a valuation that could have given the long term 6.5% average annual rates of return.

However, historically, the market has offered even better returns and if one believes in regression to the mean, then likely, we're to see lower share prices and better investment opportunities in the years ahead.

Today, we're back below 0% based on the model. The market today is priced to provide 0% inflation adjusted annual rate of return over the next 15 years.

In the aggregate of the stock market, there is not much value here.

What about bonds?

Short also provides us with this Chart of the 10 year Treasury Bond, with inflation adjusted yields.

(Click to enlarge)

The 10 year Treasury Bond is currently paying 2.25% and inflation is currenly 2.87%.

We can't predict the future rate of inflation, but so long that it's above 2.25%, that Treasury Bond will provide negative real rates of return for as many at 10 years if you were to buy it today.

In the aggregate sense, there is little value in both stocks and bonds at current prices. But perhaps stocks offer a better chance of having less losses in real terms than bonds over the next 10 - 15 years as I think it's more likely that we'll have more inflation ahead.

The real strategy investors are faced with today is allocating your wealth in a hedging manner so that inflation doesn't eat away all our wealth.

We're all fighting against inflation. The Federal Reserve is hell bent on preventing deflation, which would usher in a deflationary depression and banks would fall, and the Fed surely doesn't want the banks to fall.

Although gold and silver do not pay any income as you hold them, they do offer an alternative as a way to preserve wealth as the supply of both cannot be printed out of thin air as money can be. The metals themselves will always be in demand, silver for industrial but more so these days for investment.

The total money supply, as measured by John Williams of Shadowstats.com, calculates M3 growing at about 5% year over year. M1 is growing 18% year over year and M2 9.9% year over year.

(Click to enlarge)

When I worked in manufacturing, our customers always demanded lower prices for our products, which were printed circuit boards. We met those demand by increasing our productivity and efficiency with the use of technology and better industrial engineering. So gains in productivity help prevent prices from rising too much. But today, productivity rates of workers as measured by the Bureau of Labor Statistics shows year over year gains of under .5%.

(Click to enlarge)

Between low rates of productivity and money supply growth, that looks like inflation to me.

Owning gold and silver and waiting for better investment values to come could well be a good strategy as you allocate your capital within your estate.

Disclosure: I am long CEF.