Stocks Cheap? Don’t Believe It

“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.”