Are Stocks Still Cheaper Than Bonds?
Due to the recent sell-off in the Treasury market, I though it would be useful
to reexamine the relationship between stocks and bonds in an effort to determine
whether or not stocks stocks are, in fact, still undervalued on a relative
basis–as Treasuries are now significantly cheaper than they were a month ago.
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 1987Â
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
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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 4.17%, the S&P is valued at
979, and the forward earnings value for the S&P is 57.15. And after
plugging the values in the above formula, we get a reading of -.28, which,
according to the model, is telling us that the stock market is 28%
undervalued–for reference, the model was measuring a 41% value last month
when bonds were significantly more expensive. So, the disparity between the
value of the two instruments has indeed been corrected somewhat, but stocks
nevertheless remain under-priced. Of course one could argue that a more
appropriate valuation in the model will result from a continued sell-off in
the Treasury market. However, due to the current low levels of capacity
utilization in the US economy, it is most likely that the Treasury market
decline will abate.
Edward Allen