Thursday, September 2, 2010

Forget P/E ratios, where is risk headed?

The P/E ratio, as an indicator of value is being criticized as investors are fleeing risky assets, creating what some think is a bond bubble:
The rush into bonds has been so strong that last week the yield on 10-year Treasury Inflation-Protected Securities (TIPS) fell below 1%, where it remains today. This means that this bond, like its tech counterparts a decade ago, is currently selling at more than 100 times its projected payout.

If this is an "over reaction" to the volatility in the market, then the obvious bet is stocks, not bonds:
From our perspective, the safest bet for investors looking for income and inflation protection may not be bonds. Rather, stocks, particularly stocks paying high dividends, may offer investors a more attractive income and inflation protection than bonds over the coming decade.

...Today, the 10 largest dividend payers in the U.S. are AT&T, Exxon Mobil, Chevron, Procter & Gamble, Johnson & Johnson, Verizon Communications, Phillip Morris International, Pfizer, General Electric and Merck. They sport an average dividend yield of 4%, approximately three percentage points above the current yield on 10-year TIPS and over one percentage point ahead of the yield on standard 10-year Treasury bonds. Their average price-earnings ratio, based on 2010 estimated earnings, is 11.7, versus 13 for the S&P 500 Index. Furthermore, their earnings this year (a year that hardly could be considered booming economically) are projected to cover their dividend by more than 2 to 1.

However, the rush into bonds may make sense if investors are "fleeing" risk. Remember that investors have to be compensated for bearing risk, and the high bond prices could be justified by high levels of stock price risk. If so, then getting into stocks makes sense if you expect risk to go down, relative to where it is right now.

Here is a graph of the Volatility Index (in blue), invented by colleague Bob Whaley.  Log stock prices are in red.  As volatility increases, stock prices decline, and vice-versa.  If you think volatility is going higher, then stock prices will decrease, and bonds may not be a "bubble."

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