Equity investors just can’t catch a break these days. Back in March when Bear Stearns (NYSE:BSC) was taken under by JPMorgan (NYSE:JPM), the trailing P/E ratio on the S&P 500 was 19.06, which translates to an earnings yield of 5.25%. At the same time, the 10-year US Treasury was yielding 3.31%, which meant that relative to Treasuries, the S&P 500 was nearly 60% undervalued.
In the chart below, we show the historical valuation gap between stocks (S&P 500) and bonds (10-year US Treasury) since 1962. When the gap is in the green zone, stocks are considered undervalued relative to bonds, while readings in the red zone indicate that stocks are overvalued compared to bonds.
While the S&P 500 has declined by about 2% since March 17th, earnings have declined even faster. This has resulted in an increase in the S&P 500's P/E ratio from 19.06 to 22.80. At the same time, the yield on the 10-year Treasury has also risen from 3.3% to 4.0%. Therefore, even though the S&P 500 has declined, the valuation gap between stocks and bonds has actually declined by 30%.
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