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April 24, 2009

Comments

Interesting T Bone. Yes, your model is incredibly sensitive to inflation much like any discounting exercise. Here is another thought, might the equity risk premium be a bit lower because of such low nominal rates. If I read your piece properly that assumed rate looks like an ERP methodology. Interesting, but just cuff the inflation assumption - you know what Keynes said about models: better to be vaguely right than precisely wrong.
JR

JR-
You're right. The way to look at it is the real rate of return for equities priced in today is 4.5%. Plus you own the inflation hedge. If high grade corporate debt is providing roughly the same nominal return based on a 2% inflation assumption (which it roughly is), you are getting the same return with less risk but instead you are short the inflation hedge. If you have a clear view that inflation will be low, favor fixed income, if you have a clear view that inflation will be higher than 2%, favor equities. If you aren't really sure (like most of us), then own both and you're diversified.

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