Cheap is in the Eye of the Beholder

There was something of an odd Heard on the Street article in yesterday’s Wall Street Journal titled Are Stock Investors Asleep At The Wheel. Based on the title I figured it would have a bearish tone along the lines of investors bidding up stocks as they whistle past the graveyard of failed European countries.

Actually it was a bullish article using stats like global growth rates exceeding 4% as being one catalyst although growth rates above 5% are normal based on recent times. Citing stats from Morgan Stanley the article notes that European stocks are yielding 3.8% versus a bond (undefined in the article) yielding 3.4% making a ratio of 1.1 versus an average of 0.75. Also mentioned is the loose monetary policies of many countries creating an inflationary environment which favors stocks over bonds.

The article closes out with:

But given strong corporate balance sheets, healthy profits and—barring a euro-zone meltdown—a likely continued, if bumpy, recovery, stocks should maintain their poise.

In thinking about stocks being cheaper than bonds, I am on board with that. I’ve been writing for ages about how expensive bonds are, conceding that they can become more expensive which is what has happened if you zoom out a little and look at the last couple of years. Buying high, all time highs actually, becomes a problem at some point which is why I have kept maturities very short in client accounts.

The various ways people look at earnings results in various PE valuations. If PE ratios are number one or two on your priority list then you have some preferred method you rely on but I don’t think there are any PE studies that would show stocks to be more expensive than bonds right now.

None of the above however includes any sort of accounting for current events or forward looking analysis. I don’t know if the article is saying not to assess current events or do any forward looking analysis but it certainly doesn’t give a whole lot of ink to those subjects.

If expensive bonds can get more expensive then cheap stocks can get cheaper. This is meant to be an incomplete statement as buying a stock based solely on it being cheap by some measure is also incomplete. In looking at the 3.8% dividend yield of European stocks this does not seem wildly cheap as European stocks generally yield more than domestic stocks but based on the conclusion that barring a meltdown in Europe…well even if there is no contagion you have a monetary union with some level of dysfunction, lousy demographics, lousy growth prospects and lousy economic stats. If the above pertained to Paraguay (just an example that is not really an accessible investment destination) it would take you one minute to decide no way.

Again, assuming no meltdown in Europe.

Buying a cheap market with lousy prospects seems short on logic. This differs from the occasional scary event like we used to have in decades past. The markets in question, these being big Western Europe (and the US and Japan for that matter), have been dealing with long term fundamental issues for years now, as reflected in stock market results for the last elven years, with no clear path to resolution.

If you buy into the above paragraph then what priority should cheap take over broken? I obviously think broken is far more important which is why I write so often about buying into investment destinations that are on firmer economic footing with reasonable prospects for equity market prosperity.

As far as loose policy creating an inflationary environment that favors stocks, that assumes a lot of normalcy, more than we might want to count on. I forget who said this but, and I’m paraphrasing, inflation is easy to create except when you need it.

I’ll close out repeating a point from above because I think it is a good one and not previously articulated in this manner; if the above pertained to Paraguay (just an example that is not really an accessible investment destination) it would take you one minute to decide no way.

About Roger Nusbaum 169 Articles

Roger Nusbaum is an Arizona-based financial advisor who builds and manages client portfolios using a mix of individual stocks and ETFs. Roger writes a popular blog, which focuses on risk management, foreign stocks, exchange traded funds, options etc.

Roger has been recognized by many in the investment management industry for his expertise in portfolio management. Roger has been regularly interviewed by the financial press, trade journals, and television news shows. He has also had numerous technical articles published and has been quoted in a number of professional trade journals, newspapers, and consumer finance magazines. He appears frequently on CNBC Asia as a market commentator.

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