We have reviewed long-term P/E and yield data on the S&P 500 relative to historic comparison with government debt and inflation. We conclude the S&P 500 may have 10% further to go, but the valuation of government debt appears a concern.
After the recent strong rally in U.S. equity indices-- over 8% YTD and 25% from October's lows for the S&P 500-- now is a good time to take stock of the market's valuation.
Equity market less cheap, not expensive yet
Though the market is less cheap than it was, it may rally another 11% to reach normalized levels over the past decade on both a P/E and valuation basis. The risk/reward is perhaps less favorable than it was, but it is difficult to argue that equities are overvalued currently on a historic basis when looking at the past decade. This is because much of the recent rally represents recovery from undervaluation rather than moving into expensive territory.
Main risk seems to be in government debt
As I have written before, the main source of risk currently appears not in the equity, but the debt markets, where the traditional relationship between yields and inflation appears to have broken down. Of course, this is due to the actions of the Fed in Operation Twist and speculation over QE3, but it appears that there is a greater risk of falling bond prices than falling equity prices. The counterpoint to this is that the Fed is a powerful force and can determine interest rates longer than the typical investor can remain solvent.
Disconnect between equities and bonds
The disconnect between equities and bonds poses a problem, because with equities getting closer to normalized valuation levels, the traditional substitute of bonds is a less viable option. As a result, selling down equities appears sensible into future strength because at an S&P 500 level of 1500 the risk/reward starts to look fairly neutral, but a simple switch into bonds may actually serve to increase risk rather than reduce it.
Cyclically Adjusted Price to Earnings For S&P 500
Below we show the current S&P price relative to the average earnings for the prior 10 year period on a rolling basis. This is a metric that Robert Schiller created to normalize through the business cycle, so it avoids excessive noise from current earnings being especially high or low due to the business cycle. The current level is 22.5x, but 25x was a viable level for much of the decade, suggesting some upside (approximately 11%) from current levels. However, at the point of 25x cyclically adjusted earnings, the risks would appear to be to the downside, that would occur at an S&P level of 1508.
S&P 500 Dividend Yield
The chart below shows the yield on the S&P 500-- the current level is just under 2%, whereas 1.75% was the normalized rate pre-recession. That once again suggests 11% upside on the S&P 500. It is interesting that we obtain similar results for both indicators, especially given that earnings are averaged over a 10 year period whereas the dividend yield is current.
10 Year U.S. Treasury Yield
Before the market was rallying, yields were falling and the 10 year yield is now bouncing around the 2% level. This could be a positive sign for equities as willingness to accept lower yields on government debt might also indicate willingness to accept lower yields on equity investments, which would cause the markets to rally. It appears this is symptomatic of the activities of the Federal Reserve, as much as market's appetite for risk.
U.S. CPI Inflation
Finally, we look at the annual change in U.S. inflation as measured by the CPI. Again, the disconnect with bonds appears as yields are falling when inflation is rising, and increasing inflation could also be a negative for equities, though 3% is a reasonable level for inflation and we would need to see a sharper increase for the markets to show concern. In addition, the pick up in inflation might be viewed as an indicator of increasing economic activity, which is a positive for equities.
Data source: Robert Schiller
Trying to predict short term moves in the market is a daunting task at the best of times, but there is insufficient evidence to justify exiting equities at the moment. This is because the recent rally has corrected a particularly cheap market, rather than moved a neutrally valued one into expensive territory.
Nonetheless, once the S&P 500 reaches 1500, the risk/reward becomes neutral at best for equities. Relative to equities, the behavior of the debt markets appears far more interesting at the moment, with the relationship between yield and inflation apparently breaking down from its historical norm-- and that is where I would sound the most caution.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.