I had a good discussion with a friend about the "normal" level of interest rates. I know you are thinking, "What scintillating discussions!", but please contain your excitement ;).  

Above is a graph of "EXPECTED" real interest rates from 1960-2012.  I'll put quotes around expected because I am doing a quick and dirty analysis and not being particularly careful.  For those that care about the details I did use, I used an average 10 year rate for the year (so this assumes the market is basically efficient) and I used the inflation rate for the previous year (so the market has some memory here).  Ideally I would use the expected inflation rate, but I do not have access to that info immediately.

I do think the basic idea will come across though.

I wanted to have an idea of how much market's expectation changed over time.  The answer is quite a lot.  In the last 50 years, we have ranged from -2.5 - to +9.4.  There have been a lot of different effects here - high and low tax regimes, inflation, (almost deflation), productivity changes, busts and booms.

On average the real return is around 2.6%.  I have been saying I would buy TIPS if the real return reached 2%, perhaps I am a bit low on my goal.  Another conclusion is that we are not in any particularly new world contrary to many pundits.

This graph shows S&P returns versus CHANGES in expected returns.  We see the proper expected trend, a decrease in expected real interest rates coincides with generally positive S&P returns.  I think there is a causal relationship here.  It can be a bit of a puzzle to see large positive real interest rate changes and positive S&P returns, but we can view this as a positive sign because I think that is where we will find ourselves this year.  Real return expectations are being ratcheted up and stocks are remaining buoyant.

As I alluded to in a previous note, it appears we are having a change in overall expectations.  Over the last few years, we have seen a downward trend in real expected returns and that may be changing.  If so, then S&P returns should see a head wind that will keep returns from exploding upwards.  Stocks should be ok so long as inflation does not get away from the Fed.  Bonds of course will face the stiffest challenge.  Bonds will suffer on a re-valuation of real interest rates.

So a re0valuation may be healthy over the long term back to "normal" levels around 2.5% and stocks can handle this while bonds will suffer.

HOWEVER, and this is a big "but" for me, the question is will the Fed "allow  a revaluation?  I am in the camp that speculates that the Fed will NOT and so will continue to keep supporting the market.  

In either scenario, spread product (corporate bonds, loans, high yield, muni) will be a good investment because they have gotten wacked (technical term) and are trading at high spreads versus treasuries.  Stocks are ok as well and I like the preferreds especially because they are safer and carry a nice yield.

I may be wrong about the Fed in which case, bonds will continue to sell off (at least government bonds).  So my conclusion is that I should eliminate my government bond exposure (TLT) and replace with either stocks or my spread product ETF's.  The only reason to hold off would be that TLT in theory would protect me if there is a crisis of some sort, which of course is difficult to predict.  Currently my weight in TLT is about 6.5%.  I may leave it there and instead look to add to my other bond positions or add to equity.