great post, carranza.
A sophisticated investor also knows that the risk that the stock will not deliver long terms returns exceeding Treasury yields is substantial. He presumably has made the investment in order to potentially capitalize on his assumption that high returns are likely. Thus, the Treasury yield comparison is relevant but only to the extent it is a measure of an investor's tolerance for risk.
i somehow think many investors consider beating bonds a foregone conclusion, which you obviously recognize to be not the case. to me, the purpose of a T-yield comparison is to determine whether the expected return (of a risk asset, such as a stock) satisfactorily exceeds the risk-free return.
because Greenspan, in his effort to keep the stock bubble from deflating, has pushed short-term yields into negative real territory, it seems many investors take this as a carte blanche to push expected stock returns very low (i.e., push up current prices).
but despite what Greenspan has done, one can get an inflation-indexed 3.5% return off of TIPS, so i take that as the risk-free benchmark which stocks must beat. currently, i believe the real expected return on the market is about on par with TIPS, which is to say the equity risk premium appears to me about 450 basis points below its historical norm.
given the choice between a risk asset and a risk-free asset offering the same return, obviously i would choose the risk-free asset. if the market comes around to this perception (i.e., my opinion), then i believe the direction for the US market is down. conversely, the direction of expected returns would improve. this situation would actually be of great benefit to younger people who will be adding most of their funds to stocks in the coming years. however, it would not benefit those who are currently overweighted in risk assets.
A more conservative investor could easily be convinced to go elsewhere based on the comparions made by Mucho and others while a more aggressive one will not be dissuaded because he is convinced his calculations could lead to higher than market returns.
let me clarify my position a bit. i think i may have given the impression that i am against risk. but this is not the case. what i am against is risk without expected reward. i actually have a pretty decent appetite for risk. for example, i am considering possible investment in the bonds of certain companies that are in or are on the verge of bankruptcy. and right now, i own risk assets without currency hedges in the following countries: Russia, India, Korea, Japan, and various countries of Oceania, South America and Europe, as well as Canada and the US. investing in third-world or second-world countries is a practice most would consider risky. i would agree. however, i may feel the risk is worth taking if the reward is sufficiently high. this is what investing is all about imho.
by contrast, i think investing in most Nasdaq 100 companies is risky, but not rewarding. |
