Are Stocks Still Cheaper Than Bonds?
When determining the attractiveness of certain investments, it is important that
market participants perform a relative value analysis. That is to say, investors
should compare the valuation of one asset to that of a competing one. Frequent
readers of my column know that I will periodically compare the relative
valuation of stocks and bonds in an effort to determine
if stocks are under/over valued compared to bonds.
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 Fed Valuation model compares the 10 year Treasury note (bonds) with the
S&P 500 (stocks). More specifically, though, it compares the yield of the 10
year note with that of the expected yield of the S&P 500. It’s easy to
obtain the yield on Treasuries, however, the expected yield of the stock market
requires some very simple arithmetic. It is calculated
by dividing the expected forward earnings of the S&P 500 by the current value of the index. Once this number is calculated, the model’s
value can be determined…
(Ten Year Treasury Yield – S&P Earnings Yield) / S&P Earnings Yield)
Currently, the 10 year note is yielding 4.36%, the S&P is valued at
1002, and the forward earnings value for the S&P is 58.24. 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 41% value in June
when bonds were significantly more expensive.
Since that time, Treasury yields have risen considerably, offsetting some of
the disparity in the model. However, two things suggest that there is more
upside potential for the stock market. First, forward earnings continue to
improve against a backdrop of improving economic fundamentals. And second,
although the long-term trend in bond yields is up, the worst of the recent
bond market sell-off is over, and, in my view, yields will stabilize below the
4.60 level for the short-term before continuing higher later this year.
