By Tom Bradley

I’ve been a bit of a downer lately, writing negatively about bonds and real estate, and pointing out that risk premiums (the opportunity to generate returns in excess of government bond yields) have narrowed for many other investment strategies. (Note: The opinions expressed in this post are strictly the views of one man and should not be interpreted as fact or reflective of what other market participants are thinking.)

These views on valuation come at a time when pension funds and other institutional investors are increasing their allocation to real estate and alternative investments (including everything with a high yield). In most cases, the money is coming out of plain vanilla stocks. Now I realize I’m comparing a short-term phenomenon (narrow risk premiums resulting from near-zero interest rates) to a longer-term, strategic shift, but nonetheless, it does beg the question, what do equity risk premiums look like right now? What are the potential returns in the asset class they’re selling?

Well, as I look across the spectrum of possible investments, I think that stocks will produce the best returns over the next 3-5 years (6-8% per year). Here is my reasoning:

  • In a world that’s burdened with too much debt and is generally spending more than it’s earning, corporations are solidly profitable and awash with cash. Indeed, Bank Governor Carney has been complaining that companies are sitting on too much cash.
  • Investors’ focus on dividends is forcing management teams to be more disciplined in their capital allocations. This can only be a good thing.
  • Companies that aren’t growing their dividends (or don’t pay one) and have a few warts on them are being severely punished. The valuation gap between predictable, dividend-growing companies and the less shiny, more cyclical ones is unusually wide. ‘Unusually wide’ anything in the investment management business is also a good thing.
  • High quality corporations are able to borrow at ridiculously low interest rates. Some are raising money even though they don’t have anything to spend it on. Needless to say, they’re ready for whatever opportunities or challenges come at them.
  • Price to earnings multiples (P/E’s), which are key valuation tools for stock investors, have moved up over the last four years. They’ve gone from being ridiculously low in 2009 to pretty average today. There’s a great debate on where the overall market is trading, but most measures show P/E’s are still in normal territory (the teens). The measure I lean on the most (the Valueline P/E, which covers a broad array of companies, mostly in the U.S.) shows stocks trading at 16 times earnings, which is dead on its long-term average.
  • By definition, a period of average valuations means half the market is expensive based on history and the other half is ... you guessed it ... fertile ground for active managers.
  • It’s also important to consider that while P/E’s are in a normal range on an ‘absolute’ basis, they are jumping off the page on a ‘relative’ basis. In other words, when comparing stocks to bonds, the valuation gap favouring stocks is as wide as any time in my budding career (it’s been 30 years since I got hired out of grade school).
  • And finally, from a sentiment point of view, I don’t mind scouring for bargains in an asset class that people are reluctant to own.

How are stocks going to do over the next few months, or 2013 overall? I have no idea. This year could turn out to be a pleasant surprise or a total bummer. But if we want to avoid owning expensive assets (the best risk control measure I know) and have a majority of our portfolios invested in securities with the highest potential return, then it seems to me stocks have to be a significant part of the mix.