In his note on the Seven Immutable Laws Of Investing, which we mentioned earlier, GMO’s James Montier slams the idea that stocks are a good buy because bonds yield so little.
One of the “arguments” for owning equities that we regularly encounter is the idea that one should hold equities because bonds are so unattractive. I’ve described this as the ugly stepsisters’ problem because it is akin to being presented with two ugly stepsisters and being forced to date one of them. Not a choice many would relish. Personally, I’d rather wait for Cinderella to come along.
Of course, the argument to buy stocks because bonds are appalling is really just a version of the so-called Fed Model. This approach is flawed at just about every turn. It fails at the level of theoretical soundness as it compares real assets with nominal assets. It fails empirically as it simply doesn’t work when attempting to predict long-run returns (never an appealing trait in a model). Moreover, proponents of the Fed Model often fail to remember that a relative valuation approach is a spread position. That is to say that if the Model says equities are cheap relative to bonds, it doesn’t imply that one should buy equities outright, but rather that one should short bonds and go long equities. So the Model could well be saying that bonds are expensive rather than that equities are cheap! The Fed Model doesn’t work and should remain on the ash heap.
Relative valuation holds little appeal to me and even less so when I consider that neither bonds nor equities are even vaguely stable assets. In general, when valuing an asset you want a stable anchor by which to assess the scale of the investment opportunities. For instance, one of the reasons that the Graham and Dodd P/E (current price over 10-year average earnings) works well as a valuation indicator is the slow, stable growth of 10-year earnings. In contrast, the bond market was happy to extrapolate the briefest peak of inflation to over 30 years in the early 1980s, and similarly was willing to extrapolate the deflationary risks of 2009 for over 10 years. Using such an unstable asset as the basis of any valuation seems foolhardy.
I’d rather consider the absolute merits of each investment independently. Unfortunately, as noted above, this currently reveals an unpleasant truth: nothing offers a good margin of safety.
In fact, if we look at the slope of the risk return line (i.e., the 7-year forecasts measured against their volatility), we can see that investors are being paid a paltry return for taking on risk. Admittedly, Mr. Market is not yet as manic as he was in 2007 when we faced an inverted risk return trade-off – investors were willing to pay for the pleasure of holding risk – but at this rate, I believe it won’t be long before we are once again facing such a perverse situation. Albeit this time it is officially-sponsored madness!
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