Is the American stock market cheap now? Is it time to buy stocks? Nobody can be sure about the future direction of the stock market, because it depends on the development of the global economy. We can however compare today's fundamental parameters of the U.S. stock market with historical parameters, and that study should give us the answer to the question whether today's market can be referred to as cheap in comparison with the historical values.
The study is based on historical fundamental data of the S&P 500 index, which is publicly available, chosen for it includes 500 leading companies in the major industries of the U.S. economy and captures 75% of the coverage of U.S. equities.
In order to obtain the market valuation, we used an idea Harry Domash presents in his book, "Fire Your Stock Analyst!: Analyzing Stocks On Your Own." In his book Domash suggests comparing the inverse value of the price-to-earnings ratio (P/E) of the S&P 500 index to the three-month U.S. Treasury Bill Yield. The inverse value (E/P) represents the market yield, because it is the ratio between earnings to price. The difference (spread) between the market yield and the three-month T-Bill can serve as a gauge to the market valuation. It is assumed that as the spread gets bigger, the stock market becomes relatively cheaper.
Table 1 compares S&P 500 earnings yield to the three-month T-bill rate and the spread between them. The table also shows the following year's S&P 500 index returns. Source: standardandpoors.com, Yahoo Finance.
Year | Price to Earnings (P/E) | Earnings Yield (E/P) | Three-Month T-Bill Yield | Spread (E/P-3-Month T-Bill) | Following Year's S&P Return |
1984 | 10.00 | 10.00% | 8.05% | 1.95% | 26.33% |
1985 | 14.49 | 6.90% | 6.97% | -0.07% | 14.62% |
1986 | 16.67 | 6.00% | 5.60% | 0.40% | 2.03% |
1987 | 14.08 | 7.10% | 5.64% | 1.46% | 12.40% |
1988 | 11.81 | 8.46% | 8.39% | 0.07% | 27.25% |
1989 | 15.45 | 6.47% | 7.74% | -1.27% | -6.56% |
1990 | 15.47 | 6.46% | 6.19% | 0.27% | 26.31% |
1991 | 26.12 | 3.83% | 3.84% | -0.01% | 4.46% |
1992 | 22.82 | 4.38% | 2.90% | 1.48% | 7.06% |
1993 | 21.31 | 4.69% | 2.97% | 1.72% | -1.54% |
1994 | 15.01 | 6.66% | 5.84% | 0.82% | 34.11% |
1995 | 18.14 | 5.51% | 4.91% | 0.60% | 20.26% |
1996 | 19.13 | 5.23% | 5.01% | 0.22% | 31.01% |
1997 | 24.43 | 4.09% | 5.04% | -0.95% | 26.67% |
1998 | 32.60 | 3.07% | 4.36% | -1.29% | 19.53% |
1999 | 30.50 | 3.28% | 5.53% | -2.25% | -10.12% |
2000 | 26.41 | 3.79% | 4.84% | -1.05% | -13.06% |
2001 | 46.50 | 2.15% | 1.72% | 0.43% | -23.37% |
2002 | 31.89 | 3.14% | 1.15% | 1.99% | 26.38% |
2003 | 22.81 | 4.38% | 0.90% | 3.48% | 8.99% |
2004 | 20.70 | 4.83% | 2.42% | 2.41% | 3.00% |
2005 | 17.85 | 5.60% | 4.37% | 1.23% | 13.62% |
2006 | 17.40 | 5.75% | 4.97% | 0.78% | 3.52% |
2007 | 22.19 | 4.51% | 1.87% | 2.64% | -38.48% |
2008 | 60.70 | 1.65% | 0.22% | 1.43% | 23.45% |
2009 | 21.88 | 4.57% | 0.07% | 4.50% | 12.78% |
2010 | 16.26 | 6.15% | 0.14% | 6.01% | -0.00% |
2011 | 14.46 | 6.92% | 0.05% | 6.87% | 6.78% |
2012 | 15.02 | 6.66% | 0.09% | 6.57% | |
Average | 22.14 | 5.25% | 3.85% | 1.39% | 9.19% |
Based on table 1 and the chart above, we can conclude that the U.S. stock market is very cheap now considering the alternative investment in the U.S. Treasury Bill. In any case, all investors should be very cautious before entering the stock market, since we can see in the table above that a good valuation does not guarantee the market will rise the following year.
Another method available for the analysis of the stock market valuation is to compare the dividend yield with the three-month U.S. Treasury Bill Yield. When the stock market dividend yield is higher than the U.S. Treasury Bill yield, we can consider the stock market relatively cheap.
Table 2 compares S&P 500 dividend yield with the three-month T-bill rate, and the spread between them. Source: standardandpoors.com, Yahoo Finance.
Year | Dividend Yield | Three-Month T-Bill Yield | Spread (Dividend Yield-3 Month T-Bill) | Following Year's S&P Return |
1984 | 4.32% | 8.05% | -3.73% | 26.33% |
1985 | 4.68% | 6.97% | -2.29% | 14.62% |
1986 | 3.88% | 5.60% | -1.72% | 2.03% |
1987 | 3.71% | 5.64% | -1.93% | 12.40% |
1988 | 3.66% | 8.39% | -4.73% | 27.25% |
1989 | 3.24% | 7.74% | -4.50% | -6.56% |
1990 | 3.77% | 6.19% | -2.42% | 26.31% |
1991 | 2.92% | 3.84% | -0.92% | 4.46% |
1992 | 2.78% | 2.90% | -0.12% | 7.06% |
1993 | 2.65% | 2.97% | -0.32% | -1.54% |
1994 | 2.91% | 5.84% | -2.93% | 34.11% |
1995 | 2.31% | 4.91% | -2.60% | 20.26% |
1996 | 2.04% | 5.01% | -2.97% | 31.01% |
1997 | 1.63% | 5.04% | -3.41% | 26.67% |
1998 | 1.30% | 4.36% | -3.06% | 19.53% |
1999 | 1.10% | 5.53% | -4.43% | -10.12% |
2000 | 1.20% | 4.84% | -3.64% | -13.06% |
2001 | 1.39% | 1.72% | -0.33% | -23.37% |
2002 | 1.93% | 1.15% | 0.78% | 26.38% |
2003 | 1.82% | 0.90% | 0.92% | 8.99% |
2004 | 1.76% | 2.42% | -0.66% | 3.00% |
2005 | 1.95% | 4.37% | -2.42% | 13.62% |
2006 | 1.94% | 4.97% | -3.03% | 3.52% |
2007 | 2.08% | 1.87% | 0.21% | -38.48% |
2008 | 3.17% | 0.22% | 2.95% | 23.45% |
2009 | 2.03% | 0.07% | 1.96% | 12.78% |
2010 | 1.92% | 0.14% | 1.78% | -0.00% |
2011 | 2.31% | 0.05% | 2.26% | 6.78% |
2012 | 2.34% | 0.09% | 2.25% | |
Average | 2.51% | 3.85% | -1.35% | 9.19% |
Based on table 2 and the chart above, we can conclude that the U.S. stock market is very cheap now considering the alternative investment in the U.S. Treasury Bill.
Should investors accept the conclusion that the American stock market is cheap now, especially in comparison with the alternative investments, and if they do not fear the world is going to fall into another recession, they might decide to invest in one of the following ETFs, which represent part of the American stock market:
SPDR S&P 500 (SPY) - The investment seeks to provide results that, before expenses, generally correspond to the price and yield performance of the S&P 500 Index.
PowerShares QQQ (QQQ) - The investment seeks results that generally correspond to the price and yield performance of the Nasdaq-100 index.
iShares Russell 2000 Index (IWM) - The investment seeks results that correspond generally to the price and yield performance, before fees and expenses, of the Russell 2000 Index (small-cap segment of the U.S. equity universe).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
