Is it true that stocks are cheap when compared with bonds? The Wall Street Journal answers with a definitive “no.”
Equity proponents are pushing the argument that stocks are at record lows compared with bonds, with BlackRock CEO Larry Fink recently going so far as to recommend a 100% allocation to equities. Such comparisons didn’t “come out of the blue,” writes the Journal’s Brett Arends on Wednesday. It has a long tradition in finance, where it is known as “the Fed model,” because the ratio once appeared in a Federal Reserve report.
“The argument is pretty appealing to many—especially now, when bond yields are so low,” he explains. “The stock market today sells for about 14 times forecast earnings—or, to put it another way, if you buy $100 worth of stocks, they should generate, or yield, about $7 in after-tax earnings. That’s on par with historical averages. But that 7% ‘earnings yield’ looks enormous when compared with the pitiful 2% you’ll earn from 10-year Treasury bonds. Wall Street will offer data going back to the 1960s that shows the two yields moving in tandem.”
But, Arends asks, can you make a direct mathematical comparison between the earnings yield on stocks and the yield on bonds, as the Fed model argues?
He quotes Andrew Smithers, a financial consultant and the author of “Valuing Wall Street,” who has a four-word reply: “It’s a con job.” He has studied the Fed model in detail. His conclusion: It isn’t supported by history, economics or logic.
“It’s almost impossible to see how anybody who was in his right mind could hold that there was any validity to it,” he says, before adding, “unless, of course, he was trying to sell you shares.”
What’s wrong with this model? Plenty, says Arends.
“Take the so-called lessons of history. They’re not there. If you look at data from before the 1960s, Smithers says, the Fed model breaks down completely. The earnings yield and the 10-year Treasury yield didn’t move together at all. Or look at the theory. Stocks and bonds are very different assets. Stocks are “real” assets. Earnings and, ultimately, stock prices tend to reflect changes in inflation. But most bonds are only nominal assets, with no intrinsic value.”
When Arends heard someone pushing the Fed model recently, he started to think about overseas comparisons.
“By the model’s logic, in early 2008, both the Italian and Greek stock markets were an absolute bargain. Both sported earnings yields of about 10%, more than twice the yield on their country’s 10-year bonds. Oops.”
There’s one more problem with the Fed model, and it may be the biggest of all; it’s a relative-value “trick,” he concludes.
“Brokers aren’t saying stocks are actually cheap, only that they are cheap ‘relative to bonds.’ But so what? I remember being told in the late 1990s that certain tech stocks were really cheap compared with other tech stocks. From my window in Miami, I can see a vista of high-rise buildings where, just a few years ago, condos were marketed as a “bargain” compared with some of the others.”
LPL Financial chief market strategist Jeff Kleintop agrees with Arends’ argument, writing in recent commentary that the greater the spread between the yield on the 2-year and the 10-year U.S. Treasury notes, the more growth the market is pricing into the economy.
This yield curve peaked in February of both years at 2.9%, Kleintop noted, adding, “Then the curve started to flatten, suggesting a gradually increasing concern about the economy. This year the market is pricing a more modest outlook for growth, but we will be watching to see if the recent slight decline in the spread, currently about 190 basis points, begins to decline.”