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The new year has turned over. What is the investment outlook for 2011? About six months ago, the article Investing In A Low-Return World, looked at the investing climate in June 2010. Has the outlook improved, stayed the same, or gotten worse?

Methodology
We’ll use the same basic methodology that was used in June 2010. First, based on yields and valuations, we estimate the long-term return of investment assets. Then combine the returns for each portfolio. Risk is estimated from past history.

Inflation Expectations
Inflation expectations can be deduced from the Treasury bond market. You can find current Treasury yields at Bloomberg Government Bonds. Table 1 shows the Yield-To-Maturity for 5-, 10- and 30-year Treasuries, both nominal and inflation-protected, and the difference which is the breakeven inflation rate.

The breakeven inflation rate is a measure of inflation expectations of bond market investors. This is not completely accurate because there is a liquidity premium and an inflation-insurance premium built into the prices and yields. But we’ll assume that those two offset each other.

So inflation expectations are 2.07%, 2.33% and 2.49% over 5-, 10- and 30-years. Let’s just say that short-term inflation expectations are about 2% and long-term inflation expectations are about 2.5%.

Stock Returns
Once again, we’ll estimate stock returns were estimated using P/E10 which can be found on multpl.com. The latest value of P/E10=22.7. This is higher than when we looked six months ago. In June 2010 it was just 19.8.

The estimated long-term stock return using the formula 0.8/PE10 now comes to about 3.52%, compared to 4% six months ago. With 2.5 percent inflation, the nominal return would be about 6 percent.

Bond Returns
Bond fund expected nominal returns are again estimated by the Yield-To-Maturity (YTM), which is published on Vanguard’s website.

TIPS expected real returns are the real YTM published on the Wall Street Journal’ Market Data Center: TIPS.

Returns of Other Assets
And once again, over the long run gold should pace inflation. Gold is up about 30% in the past year and some people think it’s in a bubble. Unfortunately, since gold pays no dividends or interst, we have no valuation model for gold prices. All we can say is that the expected real return is zero over the very long term. The expected nominal return is 2.5%

Estimating Risk
We’ll use standard deviation of returns to measure risk, and use the same table of risks as before.

Table 2 show the estimates for nominal and real return, and standard deviation.

Going back to the same table in the previous article from six months ago, you will see that the table is similar except that some of the expected returns are lower than in June 2010. Both stocks and bonds went up in price since June 2010.

Conclusion
The investing climate in January 2011 looks even worse than it did in June 2010.

I’m not even going to bother calculating portfolio expected returns. Valuations are higher pretty much across the board compared to six months ago. And at that time nothing looked attractive as far as valuations. Stocks are up. Bond yields are down. And Gold is way up.

What To Do?
As far as stocks, the only choices I can see are to invest using a momentum strategy, or just wait it out in CDs and cash until stock valuations become more favorable. Maybe there will be a major correction (down 10 to 20 percent), or a bear market (down more than 20%).

The problem with waiting in cash is that the Federal Reserve’s ZIRP (Zero Interest Rate Policy) and Quantitaive Easing (QE2) are what has raised asset prices and is keeping them up. Ben Bernanke seems committed to extreme low rates for a long time. They have already been low for two years and he has not even broken a sweat. Ben can keep rates at zero longer than you can remain solvent.

On the other hand, the problem with following a momentum strategy is that the Federal Reserve could pull the rug out from under the market at any time, without warning, crashing the market for stocks and bonds.

The Federal Reserve is trying to force investors into risky assets in order to prop up asset prices, under the theory that high asset prices well make people feel wealthy and then they’ll start buying which will boost the economy. Whether or not it works, or how long Bernanke will continue down this ill-conceived path, is unknown. n the meantime, banks are making out like bandits while savers and retired people suffering.