T-bill vs. S&P 500 Earnings Yield, 1936-2007

Traditional finance [CAPM] says risk and reward have a give and take relationship that is stable.  regardless of your opinion on that, I am offering a free tool to reach your own conclusions. 

The reported PE ratio of the S&P 500 is the reciprocal of the earnings yield of the firm, there are many flaws with this, but it is a good starting point.  Historical the S&P 500 has yielded 3.3% more than T-bills.  Using that historical information lets see what "fair" value for the S&P 500 would be today. 

Here is a free spreadsheet tool for with yield premium assumptions.  The idea is to guess what you think S&P earnings growth will be next year and then come up with a "Fair Value" for todays S&P 500.  For those who think in terms of the Dow Jones, there is a crude price adjuster.

The spreadsheet requires 3 known values and 2 predictions about the future.  Using today's data and a 4% earnings growth expection the S&P 500 is 8% over priced.  A corresponding move in the Dow Jones Industrial Average DJIA would put it at 11,500.  If you believe the risk free rate should be closer to inflation instead of t-bills, i.e. 3.0%, then "fair value for the DJIA would be 8,500.  If you think the Risk free rate is higher, download the spreadsheet and check out the predictions.

 Looking at the historical data will show that these figures and the "fair value" spread vary widely over time.  Use this tool as you see fit. As they say in the auto world, your mileage may vary. 

I have included quarterly S&P 500 PE ratios and yearly T-bill yields going back to 1936 as well.  Unfortunately the T-bill data I had was only available on an annual basis.
Here is the Excel tool and associated data:

Download SPDJIAPEriskfreeyieldpredictionV1.1.xls