Tuesday, September 6, 2011

Sayonara, US Economy?


If you look at the markets for the last three trading days, one really has to wonder whether we've already morphed into a Japan-like economic malaise.

Japan was brought down by huge debt burdens caused by overspeculation in real estate. The country is now starting its third decade of economic stagnation, and 10-year Japanese government bonds yield barely over 1%.

Are we turning into another Japan?

Well, I don't think so - recent economic data indicates a U.S. economy that is still growing, albeit at a slower rate than earlier this year - but the risks of a government policy mistake loom large.

Treasury 10-year notes at this writing now yield 1.94%. With core CPI these days running at 1.8%, there apparently is a fairly large class of investors that are willing to lock in 0% real returns for the next 10 years.

In today's markets, the price for security is high. For those pundits that suggest that the world is unaware of the risks that loom in Europe and the U.S., I would suggest looking at Treasury bill yields at 0% through the end of the year, and gold trading above $1,900 - there's plenty of fear in the markets.

So how should investors be positioned?

The S&P 500 offers investors a dividend yield of 2.1%, or slightly higher than longer maturity US Treasurys.

The last time the relative yield advantage of stocks versus bonds was at this level was in 2009, in the depths of recession. Before that, you have to go back to the early 1960's to have stocks offer dividend yields as attractive relative to bonds as they are today.

The earnings yield (the inverse of the traditional P/E ratio) of the S&P 500 today stands at nearly 7%. Compared to the Moody's Baa Bond yield of 5.40%, this is a spread of nearly 160 basis points. The last time this spread was as wide as today was in the mid-1970's.

It seems to me that investors can only make decisions based on what sector seems to offer the best risk/return trade-off for the next year or so.

If one is offered the choice of a yield of 9% for the stocks (earnings yield + dividend yield) or less than 2% for long maturity bonds, the choice seems fairly clear.

Unless you think we're turning into Japan, of course.