The Best Investment Idea Is Also the Most Obvious

"Investing is all about risk and reward, but at the moment it's mostly about risk and not very much reward. Some risks aren't just badly rewarded, but are more expensive than holding the very safest forms of money.

The extra yield that can be earned above cash by buying risky junk bonds is the lowest outside the credit bubble of 2007, in data that go back to 1986. A standard, albeit flawed, Wall Street valuation measure shows the smallest extra reward for the risk of holding stocks over cash since the dot-com bubble burst two decades ago.

So why take the risk and hassle of investing, when a nice safe money-market fund or Treasury bill is so attractive? There are two basic answers. One is investors don't expect cash to stay so appealing and want to lock in future yields. The second is that after a decade when cash was trash with a zero yield, few think of cash as anything other than a temporary place to park money. That thinking needs to go, at least for now. There's little reward for venturing out of cash.

The Federal Reserve pays 4.55% to money-market funds on its reverse-repurchase facilities, part of its effort to soak up cash from the economy. That's more than the yield on safe AA-rated bonds, such as those from Apple or Berkshire Hathaway. These are companies that are rock-solid -- but they carry far more risk than cash held at the Fed or in T-bills, where the three-month yield is 4.54%.

In part this is explained by investors' expectation of rate cuts starting in the summer, expectations that intensified on Wednesday when Fed Chairman Jerome Powell didn't push back hard against the recent rally. This has resulted in an inverted yield curve, with yields on longer-dated Treasurys lower than those on short-dated bonds and cash.

But we've had inverted yield curves plenty of times before (before every recession in the past 60 years, in fact). Not since the ICE Merrill Lynch index started in 1988 has cash yielded more than safe AA bonds. Investors always demanded a higher premium above Treasurys for the extra risk of the bonds that more than offset the lower yield on longer-dated bonds during the inversion.

The difference this time is that companies are borrowing for longer, meaning the inverted yield curve lowers their bond yields more than in the past. The extra yield they pay above Treasurys, though higher than at many points in the past, is still low and not enough to bring yields back above cash.

Stocks are harder to analyze because they don't promise a fixed coupon, unlike bonds. The standard way to extract the future premium they offer is to compare cash or bonds to the earnings yield on stocks, profit divided by price, or the inverse of the PE ratio.

The earnings yield is currently 1 percentage point above the rate on a three-month T-bill, an extraordinarily low level considering the riskiness of stocks. Again, some of that is because investors are betting the Fed will move into rate-cutting mode, helping stocks.

Some of it is because the measure is flawed, comparing the nominal return on cash with earnings, which have some connection to inflation.

But much of it is because stocks are still expensive compared with interest rates, even after the selloff last year.

One way to try to fix the problems is to compare the earnings yield on stocks with the 10-year real yield, from Treasury inflation-protected securities. Here stocks offer a pickup of 4.5 percentage points over TIPS, which doesn't sound too bad. But this is the lowest extra reward since 2007.

Some might believe the risks of stocks and bonds are lower than in the past, that a soft landing for the economy is a sure thing, or simply be happy to take risk even for lower rewards than usual.

Indeed, just because risky assets are expensive compared with cash doesn't mean cash is sure to outperform. If everything goes as markets expect, rates will fall, stocks rise and those who locked in their yield on longer-maturity corporate bonds will be happy.

But think about reward for risk taken. Risk-free cash -- debt-ceiling-driven default aside -- looks very attractive." [1]

1. Streetwise: The Best Investment Idea Is Also the Most Obvious
Mackintosh, James.  Wall Street Journal, Eastern edition; New York, N.Y. [New York, N.Y]. 03 Feb 2023: B.11.