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So the World is Not Ending?

These last two weeks of trading have broken a lot of rules:

  • The 85.7% spike (22.05-40.95) was the largest weekly percentage increase in the VIX history
  • 1-year variance saw its second largest weekly percentage increase since 1990 (30%)
  • ATM implied volatility of the VIX spiked to credit crisis peaks
  • Term structure inverted to levels not seen since March 09
  • 3-month S&P 500 skew spiked to its highest levels ince 2001
  • The 29.6% decline in the VIX on Monday was the largest decline in its history

Fundamental economic data in the United States has been coming out fairly strong, but the fear has been created in the Eurozone due the PIIGS default contagion.  From the United States’ perspective, Europe (UK excluded) makes up about 24% of S&P 500 company sales.  A drop in the Euro will hurt those sales, but they will not go to zero.

In order to invest in equities and feel comfortable with a massive spike in volatility and the Eurozone de-railing, one must have some way of feeling good about valuations.  If we believe that earnings will plummet, that the global financial markets will collapse one more time, then it is best to sit in cash or buy gold.  If we believe that our economy is slowly recovering and that the world will not fall apart at the seams, then we need to figure out where to place our investments.  I have previously stated that some high dividend stocks look much better than corporate bonds from a yield and inflation protection perspective.  Now let us attack it from a slightly different angle.

Shiller prefers to look at valuations using a price to 10 year trailing real earnings.  I do believe this provides a nice long-term perspective and clearly markets the bubbles in 1929 and 2000:

In a twist to P/E ratio’s, what about the earnings yield of the S&P 500 versus 10 year treasury bond yields?  This should show the relative attractiveness of stocks versus bonds:

Historical Returns after high earnings yield/treasury rates look promising

The interesting item to note on this chart is that there were definitive time periods where the earnings yield of the S&P 500 spiked to levels that were greater than the 10 year treasury yields.  In the past 10 years we have experienced this elevated level consistently, most likely due to unnaturally low interest rates attributed to a very accommodating interest rate policy by the fed.  From this perspective, forecasted P/E is about 16 and forecasted earnings yield over 10 year treasury rates is about 2 times.  This implies that stocks are much more attractive than bonds, that bonds are overbought, or a combination of the two.

There is not a perfect measure for valuations, but from a strictly relative value standpoint with a very strong global inflation outlook, I would prefer to own stocks over bonds.  If we believe that the market is on the brink due to a complete fiat currency collapse, then gold might be the best answer.

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