Key Market Indicater Says Sell Gilts, Buy Stocks

By: FleetStreetInvest

Watch out! The next bubble could be about to burst. This also signals a great opportunity for smart investors – because a key indicator shows that now's a fantastic time to get into stocks.

In the past 24 months, emerging markets, housing and commodity bubbles have all popped with painful impact. Now, the same could happen again, but this time in the government bond market.

Whilst bubbles are usually driven by greed, they can also be the result of fear. And the credit crunch has made us especially fearful. Panicked investors have fled in record numbers from risky markets in a “flight to safety“. Investors sold stocks, and whatever else they weren't sure about, and bought ‘risk-free' government bonds, otherwise known as gilts.

But gilts are now a dangerous asset for investors. Put simply, gilts are expensive and do not make sense as an investment proposition. By comparison, stocks are cheap. My recommendation is to buy stocks and sell gilts. Let me explain why…

Sell gilts, buy stocks

One method of bond, or stock, valuation that I have mentioned before is the Fed model . It compares the potential return between stocks and government bonds and it is currently showing its most bullish reading for stocks in modern history.

We know this by taking the FTSE 100's earnings yield (earnings per share divided by the share price) and comparing it with the yield (what you get as a dividend) on 10 year government bonds. The rationale holds that investing in the stock market becomes more attractive when the yield on stocks is higher than the yields that investors can gain on government bonds. In short, a high potential return on stocks is more attractive than a low definite return on bonds and vice versa.

The Fed model indicated investors sell stocks in June and July 2007, well before the market finally cracked. Of course, the Fed model's most famous calls were in the 1987 and 2001 market crashes. Both times this model called the top of the market according to data from ING Research.

Currently, the Fed model is very bullish for stocks. In fact, it is at record levels. The forecast earnings yield on the FTSE 100 at 10.5% and the current yield on 10-year government bonds a lowly 3.5%. That puts the ‘risk premium' at a mammoth 7.0% – way above the long-term average of 4.5%, according to data provided by Citigroup.

This means that stocks aren't just cheap, they're more than twice as cheap as government debt today. This could mean both a seriously undervalued stock market… and a critically over-valued gilt market…

Gilt returns are not only terrible… they are vulnerable too

As I have said earlier, gilts just don't make sense as investments anymore. This argument is echoed by Conservative economics spokesman John Redwood MP :

“Today, you could get 1% for lending to the government for one year, just over 2% a year for lending to them for 3 years and a little over 3% for ten years. Why would you want to do that?”

The answer? You wouldn't. And the yield on that ten-year gilt is still falling. On Wednesday last week, ten-year yields fell by another quarter percent to just 3.49%.

This isn't just a terrible return, it's also a highly vulnerable return. I believe that while people may be worrying about deflation in 2009, it is only going to be a temporary phenomenon. The real worry is inflation, and the massive impact that can have on fixed income investments.

In times of high inflation, such as the late 1970s when it hit 20%, the value of gilts quickly deteriorates. “Inflation is the enemy of fixed interest,” says Stewart Cowley, the director of fixed interest at Newton. So this week's news that UK inflation is still lingering at 3% comes as bad new to bond investors.

Given the amount of government intervention, we could find ourselves in a highly inflationary environment within the year. Ten-year yields could fall further and we would be losing money in real, inflation-adjusted, terms.

Now is the time to get out of the over inflated gilt market and into carefully chosen stocks which have the potential to beat inflation and deliver decent returns.

The gilt bubble will soon burst… and the shift to equities will send the right kind of shares higher.

The time to position yourself to profit is now.

Best wishes,

By Theo Casey,
http://www.fleetstreetinvest.co.uk

Editor's note: Theo Casey is the investment director of The Fleet Street Letter. His team is currently warning of four financial “time bombs” about to go off – and why not ALL stocks are a good buy right now. To see how you can protect yourself from these dangers – and which shares to buy right now – click here.

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