Monday, December 5, 2011

Portfolio Allocations Should Favor Equities Over U.S. Treasuries

When comparing the appeal of equities to U.S. Government bonds, the conventional approach is to compare the "earnings yield" on equities (the inverse of the price/earnings ratio) to the yield on Government bonds.  But as I have argued repeatedly over the years, the return on equities is not the "earnings yield" but is instead the dividend yield, plus the growth in dividends, plus (or minus) the change in valuations.  

So I prefer to compare the dividend yield on equities to the yield on Government bonds, after subtracting inflation.  On this basis, equities today are the most attractive relative to the "real" (after inflation) yield on government bonds in the 30 years of my records.  The only exception was early in 2009, when equities were even more attractive than they are today.  Note, though, that this attraction is RELATIVE to U.S. Government bonds, not the overall bond market that includes the mortgage, corporate, high yield, and international sectors.  I'll address those sectors another time.

I would hold little to no U.S. Government bonds at current levels, as I think that current yields are wholly inadequate to compensate investors for the potential risks down the road.

Steve Lehman

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