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Is it true that stocks are cheap "when compared with bonds"? That's the line on Wall Street. If you haven't heard it from your broker yet, you will. Indeed, in a recent report, some investment strategists from big brokerages, in their enthusiasm for stocks, argued that they were at record lows compared with bonds.
The comparison doesn't come out of the blue. 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. 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 percent "earnings yield" looks enormous when compared with the pitiful 2 percent 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.
At one level, you can compare the price of any investment with any other. Do U.S. stocks appear cheaper than European ones? Is timber cheaper than farmland? Warren Buffett, recently making the case for stocks, argued that they looked a lot more appealing to him than gold or bonds.
Some investing pros are arguing that stocks are cheap, but the numbers are sending mixed signals.
7-to-2 The ratio of the "earnings yield" on Standard & Poor's 500-stock index to the yield on 10-year Treasury bonds. The Fed model says that when stock earnings outweigh bond yields by such a big margin, stocks are very cheap compared with bonds.
14 The price/earnings ratio of the S&P 500, based on expected earnings for the next 12 months. That's pretty much exactly even with historical averages, suggesting that stocks are neither cheap nor expensive.
22 The so-called P/E 10 of the S&P 500, which compares stocks with their average earnings over the past 10 years. Historically, the P/E 10 has averaged a little over 16, and investing pros who follow long-term trends say this means stocks are now pricey.
But can you make a direct mathematical comparison between the earnings yield on stocks and the yield on bonds, as the Fed model argues? Andrew Smithers, a respected financial consultant and the author of "Valuing Wall Street," 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."
Hedge fund manager Cliff Asness, who has published research on the topic, agrees. People follow the model, he says, "but they do so in error."
What's wrong with this model? Plenty. Take the so-called lessons of history. They're not there. If you look at data from before the 1960s, Asness and Smithers say, 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.
Consider what that means in practical terms. Bond yields are low today because the market is expecting very low growth and low inflation. But if that materializes, corporate earnings will rise more slowly than in the past, or may even fall. That's grounds for caution, not optimism, about stocks. It's also the case that today's profit margins are near record highs. The only way earnings are likely to grow from here is if inflation picks up. If that happens, good luck with those bonds, whose prices would plummet.
When I heard someone pushing the Fed model recently, I 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 percent, 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. 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.
Are bonds fairly valued? By the standards of history, current yields on 10- and 30-year Treasury bonds and Treasury inflation-protected securities are very low. And an ominous chorus of smart people are lining up to warn that U.S. Treasury bonds are for lemmings. They include Jim Grant, of "Grant's Interest Rate Observer," who says they are in a bubble; Jeremy Grantham, chairman of fund shop GMO; and Paul Singer, head of the hedge fund Elliott Associates. Make of it what you will.
As for U.S. stocks? By various good long-term measures, such as 10-year average earnings, they certainly aren't a steal. If your broker insists on pushing the Fed model, ask him why he isn't pitching you Japan instead. The earnings yield there, about 8 percent, is eight times the yield on the 10-year government bond. By the Fed model, they must be a good deal -- as, alas, they have appeared to be for a number of years.
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