Reverse Valuations of Stocks and Bonds

When we talk about the valuations of the stocks or stock market indexes we always use P/E ratios as valuations criterion. Also, for bonds we use the yield or coupon of the bond as a valuation measurement. In the following table I display the inverse of the common valuation ratios.

Criteria	Value
Earnings Yield of S&P 500	4.91%
Earnings Yield of Value Stocks	6.75%
Earnings Yield of REIT Index	2.48%
P/E of 30 Year Bond	21.92
P/E of 10 Year Bond	23.14
P/E of Cash (Savings Account)	25.00

Here is how I obtained these values:

• The P/E of S&P 500 is 20.36. The inverse of P/E is E/P and it is 0.0491. In percentage terms, the earnings yield of S&P 500 is 4.91%.
• The P/E of MSCI US Prime Market Value Index is 14.8. The E/P of the Value Index is 0.0675. In percentage terms, the earnings yield of the MSCI US Prime Market Value Index is 6.75%.
• By doing the same type of calculation with MSCI US REIT Index I arrived at the value of 2.48%. The P/E of the MSCI US REIT Index is 40.3.
• The earnings yield of the 30-year bond is 4.56%. So, the P/E of the 30-year bond is 100/4.56 = 21.92.
• The earnings yield of the 10-year bond is 4.32%. So, the P/E of the 10-year bond is 100/4.32 = 23.14.
• To calculate the P/E of cash, I used the Emigrant Direct’s savings accounts rate as yardstick. The current yield is 4%. So, the P/E of cash is 25.

Balanced Funds

The funds that employ hybrid investment philosophy of holding stocks, bonds and little bit of cash in the portfolio are called balanced funds. I classify balanced funds in two separate categories: fund of funds and stand-alone funds.

The fund of funds are funds that use other stock and bond funds from the same fund family or other fund families as underlying funds to allocate money between stocks and bonds. The managers of these fund of funds constantly watch asset levels in underlying funds and allocate new money so that target allocations remain constant. The good thing about this type of investment approach is that a single manager or a single fund management team does not make all of the investment decisions. The bad thing about this type of funds is that the fund of funds may add extra expenses on top of the expenses of the underlying funds. But, the low cost fund complexes like Vanguard do not charge any extra money on top of the expenses of the underlying funds.

The stand-alone balanced funds are the funds that invest in the stocks and bonds themselves to allocate the money. The good thing about stand-alone balanced funds is that they do not incur any extra expenses except the expenses of running the fund itself. The bad thing about stand-alone balanced funds is that one manager or management team makes all investment decisions.

I believe that the balanced funds are very good for people who are just starting to save and invest. The balanced funds provide less volatility than regular stock funds and the hybrid approach of the investments makes the ride smoother in the turbulent market conditions. For starters, the balanced fund provides instant diversification across all sectors and segments of the market.

One of the most important aspects of the balanced fund according to me is to ‘buy low and sell high’. The inherent architecture forces the fund manager to buy stocks when they are down or buy bonds when they are down to maintain constant target allocation. If the fund’s total assets are growing slowly as the time goes by, the fund manager must invest in the recently underperforming asset class to maintain target allocation. When the time comes to sell, the manager must sell the recently outperforming asset class and buy into the underperforming asset class. ‘Buy low and sell high’ is easy to say for us, but human nature has created a lot of ‘bought high and sold low or holding low’ situation across the investment world. I believe that the balanced funds help us overcome the pitfalls of the human emotions because the emotions are probably the biggest enemies of the investment success.

Stock Market Commentaries

I want to point out to my readers that reading the market commentary provided by mutual fund managers gives you incredible insights and valuable information about the stock market and future returns. If you like to watch CNBC or listen to financial radio shows then you should also spend some time going to mutual fund websites and reading stock market commentaries.

I myself, read numerous market commentaries and enjoy them thoroughly. Today I would like to point out market commentaries by John Hussman, manager of the Hussman Strategic Growth Fund (HSGFX). Mr. Hussman posts weekly market commentaries on the mutual fund website and I recommend you bookmark the link and read them regularly.

I absolutely loved the following list of recent commentaries:
* September 12, 2005 - The S&P 500 as a Stream of Payments
* August 29, 2005 - The 40-Year Forecast for the S&P 500 Index
* June 13, 2005 - Google, iPods and George Foreman Grills

Happy Reading.

Disclaimer: I do not own any of the Hussman Funds. I am *not* (thanks for the pointing out the omission) getting compensated for pointing out these market commentaries on my website. All disclaimers apply.

Inflation and House Prices Correlation

In a fiat currency monetary system, inflation is inevitable. The elected officials print money to create an illusion of the wealth for political gain. Inflation is a corrosive disease that eats away the purchasing power of the fiat currency as time goes by.

Consider a closed isolated economy with 10 residents. There are 10 identical homes in this economy. The residents use dallor as the fiat currency for buying and selling goods. The total money supply circulating in this economy is 100 dallors. Assuming no other needs we price 10 identical homes at 10 dallors each because 100 dallors are going after 10 identical homes. No home in this closed economy will ever go up or down in price because they are all identical and there are exactly 100 dallors available to buy them.

Now, all of a sudden, some outside entity introduces 20 extra dallors in this economy. The money supply grows 20% to 120 dallors overnight. Since the residents of this economy finds out about this newly injected dallors they immediately price the homes at 12 dallors each instead of 10 dallors. Why? This is because, there are now 120 dallors going after 10 identical homes.

Inflation went up by my 20% in our dallor economy. Why? Because the money supply was increased by 20%. What happened to the original dallors? The 10 dallors cannot buy a house any longer; those 10 dalllors have lost their purchasing power.

Let’s look at the real economy of the United States. The Federal Reserve runs the printing press and can print money at any time they want. The money supply has been growing by leaps and bound in the United States. There are three measures of the money supply that economists use:

M1: Currency, travelers checks, demand deposits and other checkable deposits.
M2: M1+ Retail MMMFS, savings and small time deposits.
M3: M2 + Large time RPS, Euro-dollars, and institution only MMMFS.

The table lists the M1, M2 and M3 from 1959 to 2005. As you can see, the M3 went from less than $300 billions in 1959 to close to $10 trillion today.

According to my calculations, the M3 has grown about 8% annually from 1959 to 2005. This is called corrosion of the money folks. This M3 growth can also explain the 6.26% annual rise in US median house prices as described in one of my previous posts.