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Saturday, May 1, 2010

Treasuries vs. Equities - Round 1

The reason I put "Round 1" here is that this will be an ongoing battle that changes with market conditions. As of right now, I would agree with the general sentiment expressed in this article from Seeking Alpha that long term treasuries are a poor place to be at the moment, with an important caveat.

If the Greece situation continues to spiral with little hope of a firm solution, long term treasuries are just about the best place to be. Every time Greece flares up slightly, treasuries have rallied. If there was a protracted debt crisis in Europe, capital would flee the Euro Zone and make its way to the U.S. and seek the safety of government paper.

If you have a modest long term treasury position, as I do myself, I don't see the pressing need to sell. If you have been moving vast amounts into bonds over the past few months, I question the wisdom of that decision. As long rates move up, which they will barring another major financial panic, you will lose money for the next couple of years. In short, your equity position should dramatically outweigh your bond position going forward for a while yet.

The article also addresses an important point about equity valuations which is that there are several ways to look at them. There is the absolute view that, for example, a price to earnings ratio (PE) for the S&P 500 of 20 is high. There is also the relative view which is that a PE of 20 in the context of a 3.70% ten year treasury rate is actually quite modest. Then, of course, there is the fundamental question of which measure of PE to use. Do you use the 12-month trailing earnings number? Do you use operating versus net earnings? Do you use a ten year trailing average of earnings as Robert Shiller does? Do you use the estimates for the next year?

I will address these differences next week in a larger post on how to value equities (an art I am still working on). Of course, you could just take that view that whatever the market pays for a stock is appropriate because all actors are rational and there is perfect information. It makes life easier... until you lose all of your money.

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