Thursday, June 20, 2013

Updating a favorite graph of mine and adding some data:





The first shows the spread between Earnings yield and 10 year Treasury notes.  The second is the absolute levels of each (Blue is the prospective earnings yield and yellow is the 10 year treasury rate)

Both are since 1961 (of no particular relevance).

If you graph the spread versus future S&P 500 returns you get a statistically significant positive relationship - higher spread, higher S&P return.  

Given that we have been high for the last few years, it should be no surprise that the S&P returns have been good.  Looking forward from now, we have a spread higher than 5% so stocks still look good.  Perhaps not so good are the bonds.  I think the average spread over time is around 2+%.  Since we are over 5%, then it stands to reason this will come down some day.  The second graph shows that probably the more likely way the spread will "normalize" is by treasury yields going up.

I think that is what we are seeing in the market right now.  The proper trade would be buy stocks/short bonds but that is a very "hedge fund/absolute return/somewhat risky" strategy.  For long term investors, the proper course is to overweight stocks and keep bonds on the lower end of their weight ranges.  

My caveat would be that while rates are low and probably should go up at some point, it would be more economically rational for rates to go up because the economy is picking up.  We have not really seen that.  So, I'll stay with my bond exposure (MHN, TLT, PFF and others) for now and wait to see some actual growth surface before I quit it.



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