Are Stocks Still More Attractive Than Bonds?
Due to the recent decline in Treasury yields (inversely related to price), I
though it would be useful to look at the relative valuation between stocks and
bonds, as they both compete for a 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 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 4.19%, the S&P is valued at
1028, and the forward earnings value for the S&P is 59.04. After
plugging the values in the above formula, we get a reading of -.27, which,
according to the model, is telling us that the stock market is 27%
undervalued–relative to bonds; 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, making stocks all the more
attractive.
