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The U.S. Treasury is ramping up its issuance of inflation-protected securities (TIPS) this year, in order to address foreign investors' concerns about soaring fiscal deficits and the inflation risk they create. TIPS issuance for 2010 is expected to increase by approximately 40% over the amount sold in 2009. Should you be following China's and Japan's impetus and raising your exposure to TIPS?

How do TIPS work?
TIPS are government bonds with semi-annual coupon payments and principal that are indexed against inflation, using the Consumer Price Index (CPI). Individuals can purchase TIPS directly from the Treasury, but the iShares Barclays TIPS Bond Fund ETF (NYSE: TIP  ) is a more convenient option. The trouble is, while TIPS guarantee a positive after-inflation return, at 1.28% for the 10-year TIPS, the current "real yield" will only inch your purchasing power forward.

Traditionally, investors have sought protection against inflation in gold and other commodities, but there may be a more straightforward option.

A tip from Bill Miller
Last Tuesday, Bill Miller, the manager of Legg Mason's (NYSE: LM  ) flagship Value Trust fund remarked on CNBC that "the top 10 names in the S&P 500 today trade at around 12 times earning ... they should trade somewhere between 14 and 18 times earnings."

By my calculations, the market-value weighted price-to-earnings ratio for the basket of these 10 stocks is actually 16.3 (see table below), but half of them do trade below 15 times earnings: ExxonMobil (NYSE: XOM  ) , Wal-Mart Stores (NYSE: WMT  ) , Johnson & Johnson (NYSE: JNJ  ) , IBM (NYSE: IBM  ) , and Procter & Gamble (NYSE: PG  ) .


Dividend Yield

Price / Earnings Multiple

Long-Term Estimated EPS Growth

Top 10 S&P 500 stocks -- market-cap weighted average




Source: Capital IQ, a division of Standard & Poor's.

Lower initial yield ... with upside
Although the average dividend yield (which is a pre-inflation figure) for this basket of 10 stocks is lower than the real yield on TIPS, I'll take the former -- along with the 11% expected annual growth in earnings per share. My guess is that this basket will outperform TIPS on an inflation-adjusted basis over the next 10 years. More broadly, asset manager GMO has "high-quality" U.S. stocks (our basket certainly qualifies) earning an average real return of 6.8% over the next seven years, a full 6 percentage points ahead of its projection for inflation-indexed bonds.

The Fed's policies are creating a new set of tangible risks for investors. Motley Fool Global Gains co-advisor Tim Hanson explains why it's time to get out now.

If you're concerned about the threat of inflation -- and other risks facing the economy -- focus on companies with sustainable dividend growth. The team at Motley Fool Income Investor can show you how to build -- and manage -- a portfolio of high-quality company stocks with robust dividend yield. To find out their six Buy First stocks, take advantage of a 30-day free trial today.

You can follow Fool contributor Alex Dumortier on Twitter; he has no beneficial interest in any of the companies mentioned in this article. Wal-Mart Stores is a Motley Fool Inside Value pick. Johnson & Johnson and Procter & Gamble are Motley Fool Income Investor recommendations. The Fool owns shares of Legg Mason, Procter & Gamble, and iShares Barclays TIPS Bond. Try any of our Foolish newsletters today, free for 30 days. Motley Fool has a disclosure policy.

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  • Report this Comment On January 20, 2010, at 2:30 PM, henryking54 wrote:

    This is a terribly simplistic article that recommends people shun bonds for stocks because stocks allegedly have a higher expected rate of return. No kidding! But just because stocks have a higher expected rate of return does not mean that people should ignore bonds.

    Complete rubbish.

    This author needs someone to educate him on portfolio theory.

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