Montreal, Canada

Are investors better off buying large-cap stocks paying a 4% dividend over the next 3-5 years or buying a ten-year U.S. Treasury bond yielding 2.96%? What would you rather own?

If we're struggling with renewed deflation now then inflation won't be a primary concern for the next few years. That's what Treasury bonds and TIPS are telling us now. It's also the message derived from the yield-curve where short-term and long-term interest rates are compressing at their fastest rate since late 2007. Credit doesn't lie. The market is beginning to price in a slowdown.

David Rosenberg of Toronto-based Gluskin-Sheff accurately called the bond rally. Rosenberg was one of the few bond bulls heading into 2010 believing a heavily leveraged American economy would act as a drag on economic growth; he doesn't believe Treasury's are in a bubble, either. Long-term Treasury bond prices have soared 23% this year.

The U.S. broader market, as defined by the S&P 500 Index, open this week 16% below its post-March 2009 high and yields 2.14% in dividends. U.S. equities are now down 8.3% in 2010 and have posted a loss for the last seven consecutive trading days. That's the worst skid since October 2008.

Another four percentage points lower and we're technically in a new bear market. Investors define a bear market for stocks as a loss of 20% or more. On that measure, several indexes are already in bear market territory, including banks, oil services and energy stocks, telecoms, retail etc. Foreign stocks as measured by the MSCI EAFE Index are also technically in a bear market. The MSCI World Index is just a few points away from that infamous threshold.

But as stocks have declined sharply over the last five weeks, dividends have risen for some of the largest stocks in the S&P 500 Index. Many large-cap companies also hold a tremendous hoard of cash – north of $850 billion dollars and the most in nearly twenty years. Indeed, some of these companies have boosted buybacks this year and hiked dividends.

Amid the growing nervousness out there this summer I wonder if an investor looking out three years or more might be better off buying and holding the likes of Johnson and Johnson (3.7% yield), Coca-Cola (3.5%), Kimberly-Clark (4.4%), Elli Lilly (5.8%) or Exxon-Mobile (3.1%) compared to sitting at near-zero percent money-markets or lowly T-bonds?

Unfortunately, barring a short-term rally, stocks have further to drop before really offering outstanding values. They didn't offer exceptional values in March 2009 and they certainty don't offer great values now, either. Exceptions, however, abound. The above five large-caps are attractive at these levels and are trading near their 52-week lows. Combined, the five yield an equally-weighted dividend of 4.1%.

Dividends, though attractive at these levels for many large-cap non-financial companies, also face the uncertainty of tax hikes in 2011. Nobody really knows where the new Obama dividend and capital gains tax rates will stand next year – and investors hate uncertainty.

Energy stocks are cheap; but again, the fallout from the Justice Department's witch-hunt and the reverberations of the BP disaster in the Gulf also raise uncertainty.

One thing is certain. The V-shaped economic recovery in the United States isn't happening. The economy is running out of steam and the second half of 2010 doesn't look too encouraging. This assumes corporate earnings expectations are too high and the market might have further to adjust.

If you choose to bargain-hunt amid a falling knife market then be sure to apply stock-hedges to your longs. If the market doesn't arrest this string of losses this week, then the odds are pretty good that we'll enter the gates of a bear market for the first time since October 2007. And large-cap stock dividends will get much cheaper.