Federal Reserve Bank of New York on May 8, released the study: Are Stocks Cheap? Review of Evidence, in which it finds that the current equity premium is at historic high levels. The media have been quick in drawing the conclusion that stocks have never been cheaper.
We think that the media have sensationally focused on the study's headlines, and failed to truly analyze the findings. Not to blame the media alone, the authors of the New York Fed study have not provided an alternative interpretation of their findings. As a result, the study has added to the bullishness with the market (SPY) (DIA) at an all-time high, potentially creating a buying panic, which can only be damaging to the investors and broadly to the economy.
Specifically, we will focus on this paragraph form the New York Fed study:
Why is the equity premium so high right now? And why is it high at all horizons? There are two possible reasons: low discount rates (that is, low Treasury yields) and/or high current or future expected dividends. We can figure out which factor is more important by comparing the twenty-nine models with one another. This strategy works because some models emphasize changes in dividends, while others emphasize changes in risk-free rates. We find that the equity risk premium is high mainly due to exceptionally low Treasury yields at all foreseeable horizons. In contrast, the current level of dividends is roughly at its historical average and future dividends are expected to grow only modestly above average in the coming years.
This is the key implication from the New York Fed study that everybody can easily grasp: stocks are potentially cheap because the Treasury yields are exceptionally low. The unexplained point that solves the puzzle is: Why are Treasury yields so low?
Treasury yields are currently near the historically low levels partially because of the QE - the Fed is buying T-bonds at all maturities to stimulate the economy, and thus artificially keeping the Treasury yields low. Thus, the equity premium is artificially high.
A more complex explanation based on the expectations hypothesis suggests that Treasury yields are currently low because the crisis that commenced in 2008 will last for a very long time. Specifically, the yield on a 10-year T-Bond can be estimated as an average yield of 10 one-year forward rates, starting with the 12-month yield for 2014 all the way to one-year forward yield for 2024. In a way, we are looking at the Fed policy for the next 10 years. The key implication is that the economy will not significantly improve over the next 10 years due to the significant deflationary pressures. Readers should revisit the Greenspan conundrum for the discussion of the yield curve. In 2005, the Fed also misinterpreted the falling long-term Treasury yields, and thus, failed to forecast the financial crisis of 2008.
Our key argument is that the equity premium cannot be used as an appropriate valuation metric for the stock market now because the risk-free rate is artificially low. Further, the low Treasury yields are potentially bearish for the stock market.
One can only revisit the Japanese example. The yields on Japanese Government Bonds have been very low for an extended period of time due to the deflationary pressures and an endless QE. The Japanese stocks performed horribly over the last 25 years (Figure 1).
We just want to caution the investors that the current PE ratio for S&P 500 is around 15 times based on the estimated 2013 earnings, which is at the historical average, but by no means are the stocks the cheapest in history. Thus, we advise against the positive feedback trading (buying panic).
Figure 1. Nikkei 225