In the 48 hours since Warren Buffett called the U.S. stock market “ridiculously cheap,” it has gotten somewhat cheaper. Bulls looking to console themselves after their roughest stretch in five months might want to consider his logic.
The Berkshire Hathaway chief executive officer cited low inflation and low borrowing costs in stating the view, which came in a CNBC interview.
He didn’t elaborate much, but his terms are consistent with a two-pronged valuation standard sometimes called the Fed model, in which corporate earnings are treated as a yield and compared with Treasury rates.
Nobody cares less about day-to-day market moves than Buffett and anyone presuming on the notion stocks are cheap has done very well in 2019. Part of his point was to ask whether rates would stay low for much longer, a concern echoed by JPMorgan Chase & Co. CEO Jamie Dimon in a Bloomberg Television interview Wednesday in Beijing.
The purpose of the following is to highlight a valuation model that differs from straight price-earnings ratios.
Here’s the math. The spread between the S&P 500’s earnings yield — a proxy for how much equities “pay” shareholders — and the 10-year Treasury yield currently sits at 2.9 percentage points. (The wider it is, the cheaper are stocks.)
While that difference began to expand significantly in December of last year and has come in a bit since, strip out the last five months and the relative payout of stocks over bonds is the highest since 2016.
So, if you believe interest rates and inflation are a relevant consideration in how much people will pay for a claim on corporate earnings, right now they suggest valuations aren’t totally nuts.