First establish fair value then determine which asset is the most overpriced

Conventional thinking is that stocks are riskier than bonds and thus as a reward for the risk therefor stocks must give a better return than bonds.

In reality stocks fluctuate above and below fair value. If you overpay for stocks during a bubble then you won’t get a reward and will have greater than normal risk.

During a prolonged flight to safety investors may pile into the safety of long term investment grade bonds making their yield seem absurdly low (from the viewpoint of someone used to the 1970’s). Thus there is risk that bonds could be riskier than stocks, but only if you assume that stocks are now fairly valued. If stocks are in need of a 33% correction because their PE10 ratio is too high then stocks are riskier than bonds.

The key is to determine fair value for each asset. The one that is the most overpriced is the riskiest.

Assuming a long term average “real rate” for long term Treasuries of 2%. Treasury prices for a 30 year bond with 1.66% inflation and 2.58% yield have a 0.92% real rate (on 7-18-12). So eventually either stocks will crash and the economy will go into recession and the real rate will be accepted by the market as correct, or rates will go up and bond prices will go down. However, to assume that because bonds used to yield 14% in 1981 that this number is a benchmark of normal conditions is wrong. The best benchmark is a real rate of 2%. If inflation goes to zero then 30 year Treasury yields will go down to 2% and bond prices will go up. If stocks need to go down 33% because the PE10 ratio is too high and bonds need to go up in value then stocks are riskier than bonds.

The equity risk premium for stocks assumes that because stocks are riskier than bonds over a hundred year average that they should also provide a greater reward. Unfortunately this premium flucuates and can go negative for decades.

I wrote an article “U.S. equities are 70% overpriced.”

Investors should seek independent financial advice.

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