Lets examine the investment yields currently offered to us by the major asset classes.
The projected return for a Bond index fund is relatively simple. The projected return is the dividend yield, with an effective time to maturity in years known as Duration. A bond fund is guaranteed to deliver this return – subject to the funds’ individual credit and interest-rate risk profile. Thus, US Corporate bond funds, having a higher credit risk, should offer a greater yield than US Government bond funds of the same duration.
Calculating the projected returns for stock indexes is not as difficult as you might expect. We can use a simple Dividend Discount Model or a projected-earnings based model. My 10-year projected returns are in the chart below. (and yes – Small-Caps and REITs have negative expected returns at current prices)
The projected returns and their Duration are presented in the chart: (click image to enlarge)
Any available investment return should be compared to the expected future inflation rate of the same duration as the investment. The expected future inflation rate can be obtained from the Cleveland Fed, and is shown as the red data line in the chart.
How to Think about Asset Returns offered by the Market
The hierarchy of investing (from least to most risky) is suggested as follows:
Base: Expected Future Inflation (we compare all investments to the inflation rate of same duration)
US Government Bonds (this is our default investment when offered an inflation-beating yield)
US Investment-Grade Corporate Bonds (when offered a sufficient yield above Govt. bonds to account for credit risk)
REITs (stocks with bond-like qualities)
S&P 500 (no need to invest in stocks unless they yield sufficiently more than Corporate Bonds)
US Small-Cap Stocks
US High Yield Bonds / Emerging Market Bonds
European Stock Index
Pacific Stock Index (increasing country risk)
Emerging Markets Stock Index (the most risky)
Look again at the chart of available investment returns and durations. Surprised to see the S&P 500, U.S. Small-Caps and REITs below the inflation line? These assets are significantly overvalued. In my opinion they don’t currently deserve your money.
You can see in the chart how the Feds’ holding short-term rates artificially low has kept US Govt and US Corporate short-term bonds below inflation as well. This pushes investors out the yield curve forcing them to take on more risk in order to beat inflation.
European and Emerging stocks do offer a compelling inflation-beating yield. They may deserve some of your funds if their volatility is properly accounted for.
US Corporate intermediate-term bonds still have a little value above US Govt. intermediate-term bonds.
I am completing a model which calculates the optimal asset allocation for these and other indexes. The model accounts for credit-risk, duration (interest-rate risk) and historic asset volatility. There are no great buys right now. Now is the time to remember that cash is also an asset.