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With the S&P having tested its 200-DMA twice in two weeks and something that may qualify as a near-term technical bottom, I thought it would be helpful to look at valuation to answer the following question: Is the S&P's possible and recent bottoming action supported by decent or even attractive valuation?

One favorite metric of mine -- and flying under the radar screen to some small degree -- is the index’s earnings yield. This is the inverse of the more well-known earnings multiple and measures an investor’s share of the composite of earnings expressed as a percentage. In being expressed as a percentage, it can be compared to the yield offered by other investment options and most notably fixed-income securities.

What’s up for debate here is the estimate for 2011. I am going to be conservative and use $93 and a first quarter consensus, as opposed to estimates that have been pushing up toward $100 more recently. This provides us with an S&P earnings yield of 7.2% off of yesterday’s close and a little bit higher than the one I provided in December of 6.6%. With the 10-year Treasury yield at 2.93%, the S&P’s earnings yield makes the bond market look more expensive than it did at the end of last year.

In other words, stocks look “cheap” judging by the S&P’s earnings yield of 7.2%. In fact, the Fed model, not sanctioned by the Federal Reserve, claims that the S&P is in equilibrium when the index’s earnings yield matches the yield on the 10-year Treasury. Clearly there’s a wide discrepancy right now, and this may suggest that bonds are likely to decline in value while stocks will gain if the Fed model is taken into account.

These remain unusually uncertain times, however, and so I think it would be a mistake to simply accept the Fed Model at face value and believe that stocks should be bought and bonds sold. Rather, I think a more sensible approach is to acknowledge the fact that until investors get some sense that the economic soft patch is just that or a soft patch through confirmation of firmer growth ahead and that Europe is not going to disintegrate in default -- orderly, disorderly or otherwise -- equities are likely to stay stuck in the intermediate-term and vicious sideways trend that has gripped the risk assets for much of this year.

Sideways, however, thus far has equaled about 1,250 to 1,350 on the S&P 500; what has made this trend vicious is that, just as it seems to break to the upside or to the downside, it holds on a bit longer as investors scrape about a bit longer looking for the aforementioned confirmation of a recovery that is on course. Should this remain true in the current moment, it strongly suggests that the S&P shall rise by about 5% from current levels.

Such a potential rise is rather different, though, than the sort that might be built upon a collective investor belief that stocks are undervalued and should be bought indiscriminately as a result. It is a tactical move within a trend of uncertainty and one that is likely to be of short duration.

That being said, such a potential tactical move is supported by the broader framework of an undervalued stock market as suggested by the S&P’s current earnings yield, and thus it may provide one more reason to think that we will, in fact, see at least one last swipe up in the vicious sideways trend and one that could turn out to be heftier than seems possible in the current environment.

In turn, the S&P’s earnings yield seems to be flashing green and this helps to buoy up the idea that a near-term technical bottom may have been put in place by the index.

Source: S&P Earnings Yield Flashing Green?