Tuesday, May 31, 2011

Dubious Conventional Wisdom

When something is repeated often enough—whether it makes sense or not—it becomes part of the conventional wisdom.  Take, for example, the assignment of a p/e multiple to U.S. Treasury notes as a way to argue that stock prices are attractive.  Yet, in Barron’s this weekend, a prominent fund manager stated that the 10-year Treasury note has a p/e of 32 ½, and it then follows that stocks are a great buy.

The return on a bond is the interest income plus the change in market value given the change in interest rates before the bond matures at par.  The change in interest rates will normally be driven by inflation expectations.  (The artificial demand for bonds by the Federal Reserve over the past two years has distorted this normal relationship.)  What are the profits of the U.S. Government, as opposed to equity in a corporation, in trying to assign the “e” in a p/e?  I suppose that if a fund can invest only in either equities or bonds that the aforementioned approach is an adequate, though crude, way to compare the two asset classes. 

But when bonds are unattractive, that doesn’t mean that stocks are a good buy.  Why isn’t cash the default when either stocks or bonds are unattractively valued?  The investment opportunity set is not just what exists today.  It also is what exists in the future, and cash reserves provide the means to take advantage of future opportunities if they’re better than what’s available now.  So I just can’t accept this bit of conventional wisdom of a p/e for bonds.

Steve Lehman

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