Stock vs. Bond Valuations

Equity investors just can’t catch a break these days. Back in March when Bear Stearns  (BSC) was taken under by JPMorgan (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%.

click to enlarge

Comments

[Charlie Stromeyer Jr]

Shouldn't you look at a chart over a longer period of time and also factor out the 1970s because during the past century inflation was abnormally high during the 1970s, and inflation is historically the worst enemy of 10 year U.S. treasuries?

Thanks.

[James Cullen]

Isn't there another way to see this - namely that interest rates are too low?

[yea ok]

Backward looking

[joof]

you should add a colored band for "periods of terror" ie credit crunches -- when people flee to treasuries and the normal spread behavior does not apply

For example....now

[Vikram12]

nice analysis. wonder how this chart would look if financials are excluded from S&P 500... Is it the huge -ve earnings from financials leading to a closing in the valuation gap?

[bearfund]

James Cullen gets the prize.

And Charlie, uhhh... exclude the 1970s because inflation was abnormally high? Is it not abnormally high now? And if not - perhaps you think 5% is a normal baseline - why not exclude the 1990s when it was abnormally low?

Furthermore, despite very high inflation today, the back half of the Treasury curve has done well. No, I do not know why. No, I do not care. This is an anomaly and the market will in time correct it.

[bsharvy]

What difference does it make whether you say "interest rates are too low" (i.e. Treasuries are too high) or stocks are too low? The course of action they indicate (if you accept the indicator) is the same: sell Treasuries, buy stocks.

[Charlie Stromeyer Jr]

bearfund, I should have been more explicit. What I meant is that the *core* rate of inflation was abnormally high during the 1970s compared with the past century. Paul Volcker finally took care of this problem and then the core rate trended lower and has stayed relatively low since then.

Note that over long periods of time in the U.S. economy that the headline rate of inflation has converged towards the core rate.

Disclosure: short 10 year Treasuries since a yield of 3.52

[JohnB]

Why is the ratio of 1.0 "fairly valued"? Shouldn't equities have a higher earnings yield (equity risk premium) due to their volatility?

And shouldn't you be comparing real yields (less inflation)?