Volatility has entered the market in a big way with the Fed in focus, and while near-term fears are somewhat warranted, we don't really understand the calls for a 20%+ sell-off in markets from here. The truth is that stocks remain considerably more attractive than bonds, and we would need to see some combination of dramatically higher Treasury yields or a significantly lower earnings yield in order for that not to be the case.
By our calculation, if the market multiple doesn't expand, the 10-Year Treasury Yield would need to look more like 4% in order for the stock market to look capped from a valuation standpoint. Even two rate hikes this year in both September and December wouldn't drive the 10-Year Treasury Yield to 4%, so we think markets have lots of room to run higher into the end of the year behind multiple expansion.
Here's the math. At just under a 25x multiple, the S&P 500 is yielding just over 4%. Meanwhile, even with the recent run-up in Treasury yields, the 10-Year Treasury Yield sits around 1.7%. That means the current Earnings-Treasury Yield Spread is roughly 2.3%, lower than what it has been over the past 5 years but significantly above where it has been since 1980. Since 1980, the average Earnings-Treasury Yield Spread is -0.47%, meaning the 10-Year Treasury Yield is normally higher than the S&P 500 Earnings Yield. Excluding recent accommodating and abnormal monetary policy, the average Earnings-Treasury Yield Spread between 1980 and 2008 was -1.28%, meaning under more normal fiscal policy which we are presumably heading into, the 10-Year Treasury Yield is normally more than 1% higher than the S&P 500 Earnings Yield.
We have a long ways to go to get there. In the chart below, we can see that stocks have been and continue to remain a considerably more attractive investment than bonds because of abnormally low interest rates. Even a handful of 25-basis-point hikes from the Fed wouldn't push the spread to 0 unless we concurrently saw significant stock market multiple expansion (which inherently implies upside for the stock market).
Although averages indicate that the 10-Year Treasury Yield is normally higher than the S&P 500 Earnings Yield, we actually think the equity yield should approximately equal the 10-Year Treasury Yield with growth of equities offset by higher risk of equities. Under this view, we have to get some combination of dramatically higher Treasury yields or dramatically higher stock multiples in order for stocks and bonds to look equally attractive.
Because a few Fed rate hikes won't get the 10-Year Treasury Yield to 4% in the near term, we think the market has lots of room to run higher into the end of the year behind marked multiple expansion. Maybe some time next year, the 10-Year Treasury Yield and S&P 500 Earnings Yield will be more on par with one another. At that point, we will reassess our bullish outlook on stocks, but until then, we think stocks will remain the most attractive asset class.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.