Bonsai Investments

What if I were to tell you the safest investment you could make right now is stock in a specific financial company? You would probably think I’m crazy. How about if I said buying gold right now isn’t safe?

The questions above are relevant because of the situation. Picture a brick on the side of the road. It’s completely harmless. Now picture the same “harmless” brick being dropped over the side of a building. It has now become a potentially lethal projectile. The only difference is the situation.

If you were to buy gold in 1987 where inflation adjusted prices were similar to today, you would have lost over half your investment over the next 14 years. If you adjust for inflation, you would have lost over 75% of your buying power. So if your investment in 1987 would have bought 4 hamburgers, in 1991, it would have only bought about 1. Clearly gold is not resting safely on the ground at current prices.

Now consider General Electric (ticker: GE) and Wells Fargo (ticker: WFC). These two financial institutions (GE’s Consumer and Commercial finance units provide a significant amount of their earnings) are AAA rated by the major credit ratings agencies, have two of the best CEO’s in the world in Jeffrey Immelt and Richard Kovacevich, and currently trade close to the lowest price to retained earnings ratios in the past 20 years. Their dividend yields alone provide a better return than 10 year government bonds. Now this is the kind of investment that I would call “solid gold”.

Pure academics have written books about the estimated future returns of stocks and bonds, but I like to keep it simple with a formula that uses price, earnings, and inflation. Mathematically, the equation is: (earnings / price * 100) + the inflation rate. Today, I calculate (1 / 17.02 * 100) + 2.1 = 7.98% as the long-term future return of stocks in the United States. Compare this to the long-term return of government bonds of 4.28% (30-year government bond yield), and equities look particularly attractive. This doesn’t mean stocks will return more money than bonds in 2008, but odds are very good they will return substantially more money over the next 5 years.

Now, to contrast, here is a rough calculation of January 1st, 2000. The stock market traded at more than 30 times earnings, and the 30-year bond yield was over 6.5%. The estimated return of stocks was (1 / 30 * 100) + 2.1 = 5.43%, more than a full percent below the expected return of long-term government bonds at the time. The return since then is pretty dramatic. While the S&P 500 has had a negative return since then, an investment in the mutual fund BTTRX (an American Century mutual fund that invests in government bonds maturing around 2025) would have more than doubled with far less risk averaging over a 9% return.

Based on this formula, I don’t recommend an investment in all bonds or all stocks at any given time, but a combination of the two in a ratio favorable to the expected future returns. An analogy I love to use is a coin toss. I can’t tell you whether one coin toss will result in heads or tails, but I can be pretty certain that 1000 coin tosses will result in about 500 of each.