How Cheap Are Stocks? (2 Views)

by: Cam Hui, CFA

In the current low-yield environment, money has been piling into the income investment theme by driving down the yields on anything that has a yield. In particular, dividend paying stocks have been a major beneficiary of this trend. Recently, Morgan Stanley highlighted how far this investment mania has run in their 2013 investment outlook document by pointing out the earnings yield on stocks is now higher than high-yield bonds (via Business Insider).

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Stocks are cheap and junk bonds are expensive. Right?

My view is that on a relative valuation basis, that view is correct. Stocks are cheap compared to high-yield bonds, but they aren't screamingly cheap on an absolute basis. Consider this chart of the market cap to GDP ratio (via VectorGrader), which is a proxy for the Price to Sales ratio. (A related ratio, namely the market cap to GNP, is one of Warren Buffett's favorite valuation metrics.) Note how the ratio, shown on the top panel, is falling and still hasn't gotten back to its long term average and it is nowhere near levels where secular bull markets tend to begin. As well, falling market cap to GDP eras tend to be associated with secular bear markets, where stock prices (bottom panel) tend to be range-bound.

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These conditions suggest that the income theme is overdone, but stocks aren't terribly cheap. Investors should adjust their return expectations accordingly.

Disclaimer: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.