Given the present economic outlook, what is the best strategy for investors? Let's look at three asset classes in reverse order. I will rank them from worst to best.

Bonds are the worst asset class for investors. Usually thought of as the safest of investments, they are anything but safe today. At a yield of 2.25%, the 10-year U.S. Treasury note is a sure loser.

Even if the overall inflation rate is only 2.25% over the next decade, an investor who holds a 10-year Treasury until maturity will realize a zero real (after-inflation) return. If the investor sells prior to maturity, it will likely be for less than the face value of the note if the inflation rate rises.

Even if the inflation rate remains moderate, interest rates are likely to rise to more normal levels as the economy continues to recover. Investors with long memories should recall that over the entire period from the 1940s until 1980, bonds were a horrible place to be. Given the likely trends, U.S. Treasurys and high quality bonds are likely to be extremely poor investments and are very risky.

Equities on the other hand are still attractively priced, despite their substantial rise from the October 2011 lows. A good way to estimate the likely long-run rate of return from common stocks is to add today's dividend yield (around 2%) to the long-run growth of nominal corporate earnings (around 5%).

This calculation would suggest that long-run equity returns will be about 7%-five percentage points more than the safest bonds. This five-percentage point equity risk premium is close to the historical average.

A variety of valuation metrics (such as current multiples of earnings and book values) suggest that equities are still reasonably priced today. Only the so-called Shiller price/earnings ratio (based on the past 10 years of earnings) would suggest that stocks are too high. But the average earnings over the past 10 years are likely to be well below the current normalized earning power of U.S. corporations.

Emerging market equities are particularly attractive. The price-earnings multiples for emerging markets have traditionally been about 20% higher than for U.S. stocks. Today they are 20% lower. Over the long run, emerging markets have better demography (younger populations) and better fiscal balances than the developed markets. And they are likely to continue to grow at a far more rapid rate than the developed world.

David Fuller's view While 10-year US Treasury yields have risen over 50 basis points in less than two months, they are still discounting a high possibility of deflation. This is, of course, the prospect on which Mr Bernanke has staked his entire career at the Federal Reserve by saying that it will not happen. Since Mr Bernanke controls the US monetary levers, I would not bet against his chances of keeping deflation at bay.

Others may fret about the longer term consequences of this policy, with good reason I will add, but Mr Bernanke will not be deterred from fighting fear of deflation and increasingly, the other half of his dual mandate concerning unacceptably high unemployment, in an election year, no less.

Regarding one of Mr Malkiel's statements above:

"But the average earnings over the past 10 years are likely to be well below the current normalized earning power of U.S. corporations."

I think it depends on which companies we are talking about. The big, successful multinational Autonomies that Fullermoney has long favoured have proven that their earnings are not determined by the US economy alone. However, some of these look temporarily overextended relative to their trend mean, approximated by the rising 200-day moving averages.
Mr Malkiel also points out that emerging market PERs have reverted from 20% above to 20% below those of US stocks. I believe this is due mainly to somewhat tighter monetary policies in what I prefer to call the growth economies. This has led to a temporary fashion for US equities relative to those of most other markets. It has momentum behind it, particularly from the tech-heavy Nasdaq 100 Index. Nevertheless, to the extent that growth economies have the strength to boost earnings among US Autonomies, they will also lift profits among many of their own companies.