Tough times can lead to chances for reassessing the roles of asset classes. Tom Sowanick is CIO of Clearbrook Research, part of Clearbrook Financial, a Princeton, N.J.-based wealth-management service provider.

Irrational pricing seems to be controlling both the stock and the bond markets. The yield for a two-year Treasury note is a full 125 basis points below the 4.5% fed funds rate. In addition, the earnings yield for the S&P 500 is nearly 200 basis points higher than the fed funds rate. Such pricing schemes point to each market offering asymmetrical total return profiles over the next six to twelve months.

We'll examine the bond market first. Let's assume that the yield on the two-year note will trade either at 4.27% or 2.27% over the next 12 months. The total return generated from yields moving to those levels would be 2.37% and 4.15%. Though these returns look symmetrical, they are so low that owning a two-year note at these levels seems irrational, even if the Federal Reserve continues to cut interest rates enough to allow two-year yields to drop 100 basis points from current levels.

Choices

Now, let's take a look at the stock market. The S&P 500 is currently priced to a 5.6% earnings yield and 6.5% on a 12-month forward basis. Arguments could be made that earnings estimates are far too positive and, therefore, the earnings yield is misleading. There is no way of knowing this in advance. A similar argument could be made about the Fed, in that the bond market is pricing in a fed funds rate of 3.5% twelve months forward. Unfortunately, the bond market has no better knowledge about what the Fed will do in the next year.

With so much uncertainty in today's market, investors are left with several, perhaps unsavory, choices. Buy bonds and hope that the Fed takes the fed funds rate well below 3.5% Buy stocks and hope that earnings surprise on the upside Ignore both of these options and move into all cash

Investors should have well-diversified portfolios that cross many asset classes and investment vehicles. In such a low interest-rate environment long-term investors may want to consider the equity market as an alternative source for income. Dividend yields of 3% and higher with the potential for capital gains seems a more compelling answer for income needs than the bond market. Investors don't always understand that bonds can be risky. They can suffer price erosion that, from time to time, equals or exceeds that of the equity market.

Market turmoil often means that stocks are under priced and bonds are over priced. That's what's going on now. Market turmoil also scares investors into paralysis. As a result, they miss opportunities to switch from expensive to inexpensive asset classes. Investors should think about using equities in a portfolio for income and, at the same time, understand that bond prices become sensitive in a low interest rate environment. -FWR

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