The Best Risk Reward Proposition

Asset allocation has been a vexing issue for investors recently.

Because of our expansionary monetary policy (low interest rates, printing money) and stimulative fiscal policy (unprecedented budget deficits), inflation is inevitable. Fixed income is not the place to be during inflationary cycles because bonds are pulverized under the pressures of inflation, as does the purchasing power of their coupon payments. As an asset class, bonds are currently misunderstood and mispriced, with more risk than appears at first glance.

What about real estate? At the end of the first quarter of 2009, about 27% of all outstanding mortgages in the U.S. had negative equity, and that number may double before the housing market stabilizes. Some experts expect half of commercial real estate loans to be in default by next year (compared to a historical average of just 4%). Moreover, they expect severity of losses to be 40%, vs. a historical loss severity of just 10%. Those numbers are truly staggering.

People are now "strategically" defaulting even if they still have a job, as they lost hope of recouping the purchase price of their home, and can now rent a similar house at a price lower than their mortgage payment.

In addition, most banks do not have enough reserves to cover their losses from real estate still on their books. If they took the appropriate marks on their loan books, they would probably be insolvent.

This will be a different kind of inflationary cycle. The dollar will decline, but Real estate prices will not be going up because few property owners can raise rents right now.

In contrast, the spread between stocks and bonds prices is the widest it has been in four decades.

Since stocks and bonds are always in competition for investors' money, it makes sense to monitor the relationship between bond yields and stocks' earning yield (the inverse of a P/E). That relationship has a major impact on equity prices. When you can buy a stock with an earning yield equivalent to that of a similar credit quality bond, the stock is more appealing because it gives you both the earnings yield and the growth of earnings over time, whereas a bond has interest payments that are fixed and aren't even protected against the eroding power of inflation.

Even after this year's rally, many stocks are still reasonably priced. Warren Buffett says if you buy stocks when the total market value of US stocks is 75% of GDP, you are likely to do well over time. We are there now, and there are unique, high quality opportunities selling at bargain prices.

For example, Wal-Mart's earning yield is 7%. Add their 2% growth rate, and you have a 9% "coupon", plus inflation (Wal-Mart raises prices in line with inflation). Compare that to the 4.5% coupon on US government bonds, or even to the average corporate bond yield of 6.17%, which are without inflation protection, and Wal-Mart seems very attractive.

Wal-Mart is currently down 7.5% for the year. Other large cap stocks present a similar opportunity, as this year's rally skipped them. Johnson and Johnson is flat for the year. Berkshire Hathaway is up less than 5%, and all three are unlevered, well managed and very reasonably priced. This is the best risk/reward proposition available to investors right now.

The stock market has a history of appreciating 31% on average in the year following a bear market bottom. I obviously don't know what the indices are going to do in the short run. But I happen to think that the panic selling crescendo in March 2009 was a generational bottom for stocks. We will not go back there even if the economy double dips.

March 2009 may be analogous to 1942, when the market averages bottomed and started a rally that lasted a full generation. At the 1942 bottom, the Dow was at 100. In the late 1960s, it was at 1,000.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at [e-mail].

Comments

[dnpvd51]

I own Potash Corp./Saskatchewan (POT) and a Norwegian company called Yara International, Peter Schiff reveals. "I think the name of the game is to find out what China is going to buy and buy it first. I expect China will enjoy a higher standard of living and start consuming more. Much more."
"Agriculture stocks and fertilizer names such as those mentioned above feed into the growing China consumer and that’s where I think investors should be."
"And Wal-Mart Stores, Inc. (WMT) is a sell because they won’t be able to import cheap goods from China anymore", adds Schiff.