The Question “Are Stocks a Screaming Buy Relative to Bonds?” Creates False Premises
by ilene - August 18th, 2010 4:49 pm
The Question "Are Stocks a Screaming Buy Relative to Bonds?" Creates False Premises
Courtesy of Mish
Josh Lipton writing for Minyanville is asking the question Are Stocks a Screaming Buy Relative to Bonds?
Dr. Ed Yardeni of Yardeni Research takes one side of the debate and says "stocks are cheap" according to a model, now dubbed the “Fed’s Stock Valuation Model”.
I am quoted in the article, taking a different view of course, but I want to add to the thoughts I expressed in the article.
First a few snips from Lipton’s article …
Certainly, by employing some basic measures to compare the relative value of stocks and bonds, equities appear attractive. Dr. Ed Yardeni of Yardeni Research made the case this morning that stocks seem cheap and bonds seem expensive according to a simple model that compares the market’s earnings yield to the US Treasury bond yield.
Yardeni first started studying this model after seeing it mentioned in the Federal Reserve Board’s Monetary Policy Report to the Congress dated July 1997. The strategist dubbed it the “Fed’s Stock Valuation Model” (FSVM), and that’s what it’s been called ever since.
During the week of August 13, Yardeni says, the forward P/E of the S&P 500 was 11.8. The forward earnings yield, which is just the reciprocal of the P/E, was 8.5%. The 10-year Treasury bond’s yield is 2.60% this morning. So its P/E, which is the reciprocal of the yield, is 38.5.
According to the FSVM, that means stocks are 64.8% undervalued relative to bonds.
James Swanson, chief investment strategist at MFS Investment Management, agrees that stocks now look cheap relative to bonds and that, as an asset class, equities boast more opportunity for investors looking ahead.
In short, the stock market is now priced for an economic future that Swanson thinks remains unlikely. “This only makes sense if the world is going into a deflationary scenario,” the strategist says. “Otherwise, this is a mispricing.”
Yes, stocks might look cheap relative to bonds, but that’s because the economic outlook remains bleak. Mike Shedlock, a well-known registered investment adviser for Sitka Pacific Capital Management, argues that the economy is already mired in deflation, a dangerous downward spiral in prices that will prove lethal for corporate profits.
"Why are Treasury yields low?" Shedlock asks. "It’s because the economy is in recession."
Furthermore, Shedlock argues that investors are ultimately best advised
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Philip R. Davis is a founder Phil's Stock World, a stock and options trading site that teaches the art of options trading to newcomers and devises advanced strategies for expert traders...
Ilene is editor and affiliate program
coordinator for PSW.