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Is This Time Really Going To Be Different? A True Look at Current Financial Asset Valuations (PG, WMT, JNJ)

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Is This Time Really Going To Be Different? A True Look at Current Financial Asset Valuations PG, WMT, JNJ
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“This Time It's Different” have been the famous last words of many investors over time. It sums up the phenomena of investors gloaming on to some new fad, technology, strategy, or valuation methodology that attempts justifying abnormal (usually higher) valuations than have historically existed. The most obvious example of this phenomenon was in the late 1990s and early 2000 where it was though that new technologies and the internet would cause a permanent increase in corporate profitability which justified extremely high valuations. Of course, just like in countless other instances, the time period was not different and valuations violently returned to ‘normal' by late 2002.

These days we are approaching levels of valuation in ALL financial asset classes that have many people again asking “is this time different”? This time the apparent justification for elevated valuations is not a new technology, fad, or investment strategy. As we enter mid 2014 the reasoning for historically high valuations in real estate, bonds, and stocks are highlighted below:

• Ultra-low current interest/savings rates (0%-1% rates on cash, 2.5% rate on 10 year treasury) • A belief that the future long term ‘normalized' level of the Fed Funds Rate might be well below the historical norm of around 4% • Long term demographic shifts around the globe of slower population growth and even population stagnation in many developed markets including the US

If the above all do turn out to be true over the longer term, this time, the ‘new valuation' believers might actually be right!

If cash rates remain near zero for decades, long term government bond yields never get above 3%-4%, and the Fed Funds rate is stuck below 2% or so a permanent change in asset valuations could be justified. Historically, over the past 100 years, stocks averaged a total ‘free cash flow' yield of between 9%-11%, investment real estate a yield of 7%-9%, high yield bonds 8-11%, corporate high quality bonds 5%-7%, and government bonds 4%-6%.

If cash and short/mid-term government bonds continue to yield 0-2% that should cause all total yields for all financial asset classes to fall. This act of yield/return contraction will keep the ‘equity risk premium' near historical levels of around 4%. The equity risk premium is the additional return over a risk free asset (cash/short term government bonds) that an investor demands for holding a risky/volatile asset. Over the past century this premium (or return differential) has averaged about 4%.

In the early and mid 1990's the 2 year treasury yield ranged between 3% and 4%, while the 10 year was closer to 7.5%. During that time if investors could get a guaranteed 3-4% on cash/short term bonds and a guaranteed 7%-8% on a longer government bonds, stocks would have to be priced to return at least 8%-10% to justify the risk of buying them. This again, shows why the equity risk premium is important to the valuation of all assets.

Fast forward to current times and the 2 year yield is around 0.4% while the 10 year is 2.5%. If these levels are here to stay for 5-10 years or more than all asset class valuations must adjust or a huge imbalance would occur. And since 2009 the ‘valuation vacuum' has put all assets back into a relative ‘balance' although on a historical basis all asset classes appear overvalued. For example, large prominent companies like Proctor and Gamble (NYSE: PG), Johnson & Johnson (NYSE: JNJ), and Wal-Mart (NYSE: WMT) that have historically returned 9%-10% per year, now look to return 5.5%-6.5%/yr. in the future. Investment grade bonds yield around 3.5%, high yield only around 5%, and real estate around 5%.

The challenge for investors now is do you accept the ‘this time is different' mantra and lock in historically below normal returns on risky assets or do you accept near 0% return on cash and ‘wait it out'.

There is no easy answer to this question, but our firm, Traphagen Financial Group, (www.tfgllc.com) has researched this problem extensively over the past several years and has developed several strategies to help our clients. Smart equity hedges, insurance linked securities, and county/sector specific investing are some strategies that we have implemented to reduce risk while not decreasing returns.

The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.

Posted-In: Financial Advisors Health Care Economics Federal Reserve Personal Finance General

 

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