Are Stocks Still Cheaper Than Bonds?

The financial markets are once again comfortable with the idea that economic reflation
will take hold–that is, investors believe that current monetary and fiscal
stimulus will indeed promote future economic growth. As a result, bond yields have
risen dramatically over the past couple of weeks–though they are still well below
their August highs.

I though it would therefore be useful
to reexamine the relationship between stocks and bonds in an effort to determine
whether or not stocks are, in fact, still undervalued on a relative
basis–as Treasuries are now significantly cheaper than they were a month ago.
The reason why this important is that both of these instruments compete for the
same limited amount of investment dollars.

One of the easiest ways to compare these two financial instruments is by using
the “Fed” Valuation Model, which was first introduced by the Federal Reserve to
the markets in 1997 when Mr. Greenspan testified to Congress. The model is a
very simple one and, admittedly, has its shortcomings. However, it can be a very
useful tool during periods of disequilibrium between the value of stocks and
bonds. For instance, it showed that stocks were overvalued in August 1987
and in March 2000 (before the stock market sold off). Conversely, it indicated
that the stock market was undervalued in October of 1998 and again in September
2001 (before the stock market appreciated significantly).

The underlying assumption made by the model is that the investment world has
two choices when it comes to capital allocation–stocks and bonds. It therefore
compares the yield of the ten year US Treasury Note with the expected returns of
the equity market. The expected return (yield) of the stock market is calculated
by dividing the expected forward earnings of the S&P 500
by the current value of the index.

(Ten Year Treasury Yield – S&P Earnings Yield) / S&P Earnings Yield)

Currently, the 10 year note is yielding 4.26%, the S&P is valued at
1045, and the forward earnings value for the S&P is 59.53. And after
plugging the values in the above formula, we get a reading of -.25, which,
according to the model, is telling us that the stock market is 25%
undervalued–for reference, the model was measuring a -23% value
at the end of August
when bond yields were significantly higher (4.6%). Most importantly however,
is that forward earnings continue to rise, which still makes stocks attractive
on a relative basis.

Edward Allen