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I have been continuing my analysis of the relationship between prevailing interest rates and reasonable equity valuations. There are a number of metrics used to determine whether the "market" is over- or under-valued; some of the metrics ignore interest rates; others give them a central role.

At a time (like now) when earnings yields and even dividend yields of many stocks are higher than various benchmark bond interest rates, the higher yield of the stocks can be explained only in terms of risk. After all, over time, dividends and earnings tend to increase, at least in nominal terms, whereas interest payments on long term bonds stay the same. The pricing of stocks today has to reflect a considerable perception of risk that earnings and, indeed, dividends will decline. This "riskiness" of stocks justifies a much higher current return to compensate investors for assuming the danger of earnings and dividends declining.

The real disconnect in this analysis is in the pricing of the bonds of certain blue chip companies. If riskiness justifies high earnings and dividend yields, why are the spreads on some of these bonds so low? Put another way, why are investors willing to accept interest rates on bonds of WMT, T, and MCD which are lower than the dividend yields on the stocks of the same companies?

We could (and should) graph the expected stock price of some of these companies by comparing interest rates on bonds of a given maturity with expected dividends over the same duration. In many cases the dividends are much higher and so the bond investor comes out even with the stock investor only if there is a substantial decline in the price of the stock. And does anybody really think that if T or MCD or WMT or XOM suddenly announce that it is skipping a dividend payment, there will be no effect on the price of the bonds?

More fundamentally, we have seen that the ability of some of these blue chip companies to borrow at extremely low interest rates provides them with attractive opportunities to refinance debt, buy back shares and make cash for stock acquisitions that are accretive to earnings. All of these things tend to reduce the danger that earnings and/or dividends will decline.

Stepping back from the immediate turmoil of the market, it should be clear by now that, when we entered the 2008 credit meltdown, many individuals and institutions were ill prepared for what ensued. I used to teach law school and, if I had to give out grades, I would give the federal government a C- for running deficits before the mess even began, households a D for being overleveraged, and financial instituions an Incomplete for being so hung over they missed the exam. But non-financial corporations should get an A+ for entering the mess with some of the strongest balance sheets in history.

As 2008 and 2009 wore on, I (and the bond market) expected the same parade of corporate bankruptcies that we saw in previous recessions and in the same industries - remember Worldcom, Kmart (NYSE:KMT), Lockheed (NYSE:LMT) (government loan guarantee), International Harvestor, etc. etc. etc. But T, WMT, BA, and CAT did not go down that path. With the very notable exception of GM, non-financial corporations pretty much weathered the worst storm since the 1930s.

So I don't really know whether the "market" (which includes the leverage addicted financial sector) is overvalued or undervalued. What is beginning to seem clear, however, is that it is smarter to own the stocks of companies like T, WMT, MCD, XOM, JNJ, PG and KO than it is to own the bonds.

And, if - as I suspect - the bond market is smarter than the stock market, then the reason is that the stocks are undervalued. Let me stick my neck out here - consistent with the low level of risk reflected in the bond spreads and with prevailing interest rates, these companies should be trading at 16-20 times forward earnings and with dividend yields clustered around 2.

Low interest rates are relevant. They create enormous opportunities for companies properly positioned to take advantage of them. When not only Treasury rates, but also rates on corporate bonds are historically low, they signal a reasonable level of risk associated with the issuer. The "market" may never be priced at a level that can be calculated with reference to interest rates, but certain stocks should be and likely will be.

Disclosure: Author is long T, XOM, MCD, JNJ, PG, KO, WMT, GM

Source: Low Interest Rates and Equity Valuations: Smarter to Own Stocks Than Bonds?