Strategy for Making Money Off The Price Disparity Between Stocks and Bonds

Back in November I wrote an article for this blog about the FED Model. In that article I mentioned that the P/E ratio of the S&P 500 was about 15.72 back then, resulting in an earnings yield (i.e., the inverse of the P/E ratio) of about 6.36%. The yield on the 10-year bond, on the other hand, was about 4.564%, resulting in an historically high risk premium (i.e., the difference between the earnings yield and the 10-year bond yield) of about 1.796%.

I checked the Standard & Poor's website today to see if the earnings estimates had changed since November. According to Standard & Poor's, the 2006 earnings projections on the S&P 500 have been slightly reduced to $76.80. As of the December 30, 2005 market closing, the S&P 500 was trading at 1248. Accordingly, the earnings yield on the S&P 500 is now about 6.154% (i.e., 1248/$76.80). Meanwhile, the 10-year bond yield has fallen to 4.395%, resulting in a risk premium of about 1.795%.

Risk premiums of well over 1% are historically very large. The average risk premium between 1994 and 2003 was about 0.11%. Accordingly, there is a strong likelihood that the current risk premium will eventually shrink to a much lower level.

To profit off this current price discrepancy between bonds and stocks and the inevitable shrinking of this risk premium, I recommend selling short shares of the iShares Lehman 20+ Year Treasury Bond ETF (symbol: TLT), and using the proceeds from the short sale to purchase shares of the S&P 500 Depository Receipts ETF (symbol: SPY).

I implemented this strategy myself on Friday, December 30th. Specifically, I sold short 25 shares of TLT at $91.9068/share and established a long position of 18 shares of SPY at $124.8388. My commissions were $5 on each transaction through my Ameritrade Izone account.

After shorting the shares of TLT, I received $2292.67 net of commissions. Including commissions, it cost a total of $2252.10 to purchase the shares of SPY. After these trades, my account looks like this:

-25 shares of TLT
+18 shares of SPY
$40.57 leftover cash from the short sale

I will post monthly updates to let everyone know how well this long-short hedge is performing.