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My goal in providing these periodic updates is to review the market’s valuation from a couple of different perspectives, as originally outlined here.
I review this information continually to make allocation and contribution decisions in my personal 401K, which only offers five index funds. My aim is to keep it simple, and focus on valuation levels and the likely outcomes for stock/bond returns looking forward, and then invest accordingly. Providing this review is a byproduct of this process.
I should point out, that although there’s a lot of hand wringing going on out there about the market and the economy, this series ignores the macro-economic picture. As you’ll see below, that information is simply not germane in the review.
Analysis:
Take a moment and look at the metrics below of expected returns and timeframes, compiled as of May 28, 2011:
Metric | Expected Return (as of May) | Expected Return (as of April) | Timeframe (Years) |
TMC/GDP Ratio | 3.80% | 3.70% | 8 |
T-Bill | 3.15% | 3.56% | 10 |
AAA Corp Bond Index | 5.80% | 5.80% | 4.6 |
The Expected Market Return vs the T-Bill:
Let’s start with a mental experiment.
Imagine for a moment, that your only two choices for investment were the S&P500 and the 10 Year T-bill. Which would you pick right now to invest in?
Judging by these numbers, the 0.65% spread between the expected market return and the T-bill represents a 20% margin of safety. In April the spread was 0.14% and represented a 3.9% margin—basically a toss-up. However, when viewed in the context of inflation, neither figure is much better than the long-term inflation rate.
Think of it this way. If you’re going to lock up money for the next 8-10 years, would you rather have it earn a likely 3.8% in stocks or a definite 3.15% in T-bills? At what point would the spread between the two make you pick stocks over the T-bill?
The Expected Market Return vs the Corporate Bond:
Recall, that in any particular company, it’s a given that stock investors, due to the increased risk with their investment, should earn higher returns than the bond holders. Additionally, we generally accept the S&P to be a proxy for business common stock—the stock of the average American company as it were. In like fashion, the AAA Corporate Bond Index can also be thought of as a proxy for business debt—or the bonds of the average American company.
Continuing the mental experiment, now imagine for a moment, that your only two choices for investment were the S&P500 and AAA corporate bonds. Which would you pick right now, knowing that you should get a lower return from corporate bonds?
The data implies that you can earn a likely 3.8% return from the average American stock or 5.8% from the average American company’s debt. It seems to me the relationship between returns is backwards… and by a significant degree; the margin of safety is not in your favor.
Additionally, when viewed in the context of inflation, it seems corporate bonds would be the better choice to preserve purchasing power, and not the stock market at current levels.
Conclusion: based on the above review of likely outcomes, it appears the market continues to be over-priced.
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If you look at the normalized price/earnings of the S&P over the past 20 years, or the S&P earnings to GDP, you'll see that the market is in fact moderately overpriced (about 5-10% overpriced).
Here's the problem. If you pick a fixed income investment, you lock in a rate and you take the risk that the fed hikes rates, and your bond becomes worth less than what you payed. The likelyhood of that occuring is high considering historically low rates. If you pick a T-bill, your margin of safety for beating the long term inflation rate of 3% is 0.15%. At least if you invest in the S&P your future earnings will be adjusted for inflation.
Now, if your argument is to invest in short term (1-2 year) fixed investments, and then capitalize on a market hiccup, thats a better strategy.
Really, you should just dollar cost average in any sort of retirement account.
Doctor Investor