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.