Bloomberg: Stocks Cheapest in 50 Years

According to an article at Bloomberg, U.S. stocks are near the cheapest level relative to bonds in 50 years. Here’s how it works: If we take the market’s price/earnings ratio and flip it over to get earnings divided by price, then we have the earnings yield. When we compare that yield to the yield on the 10-year Treasury bond, the gap in favor of stocks is close to the widest its been since 1962.

Earnings in the S&P 500 have more than doubled to $96.58 since 2009 and are projected to reach a record $104.28 this year, more than 11,000 analyst estimates compiled by Bloomberg show. The earnings yield, or annual profits divided by price, climbed to 7.1 percent, 5 percentage points more than the rate on 10-year Treasuries. That’s wider than in 97 percent of months in 50 years of Bloomberg data.

I think this analysis is basically sound; however, there are a few problems. It says that stocks are cheap versus bonds. It doesn’t mean that stocks are cheap on an absolute level. In other words, it can mean that bonds are over-priced which I think is also true.

On a philosophical level, we should remember that all prices are relative. We’ve been trained to think that all prices are expressed in dollars, but that’s a bit of a mind trick. All prices are relative to each other — dollar bills are just the middleman.

Ideally, the earnings yield ought to be compared with rates longer than the 10-year bond. What’s interesting is that rates are unusually steep after ten years. The 20-year yield is currently 79 basis points over the 10-year, while the 30-year is 115 basis points above it.

The spread was last this wide in the four months before the S&P 500 (SPX) reached a 12-year low in March 2009, data compiled by Bloomberg show. The benchmark gauge for American equities has increased 101 percent since then, including an 8.3 percent increase in 2012, the best start to a year since 1997.

Low valuations and signs of recovery have failed to lure individuals back to equities. Stocks are trading at a 14 percent discount to their average price-earnings ratio over the past five decades. The multiple has been stuck below the mean of 16.4 times earnings since May 2010, the longest stretch below the average since the 13 years beginning in 1973, data compiled by Bloomberg show.

(…)

Capital investments surged in 2006 as the total debt-to- assets ratio in the S&P 500 was climbing to 38.8 in the third quarter of 2007, the highest point since at least 1998, data compiled by Bloomberg show. The ratio is about 32 percent lower now. Companies spent the past three years paying down debt and cutting costs, boosting the S&P 500 profit margin to 13.8 percent, compared with 8.3 percent in 2009, the data show.

S&P 500 companies increased cash and equivalents for 12 straight quarters to $998.6 billion in the third quarter, 60 percent more than in September 2007, just before the index reached an all-time high of 1,565.15, according to S&P. The total excludes financial, utility and transportation companies.

I caution investors that while this analysis is very useful, don’t get too caught up in models. All this is based on projections. Outside of a few months, forecasters don’t really have a good idea of what’s going to happen. They’re usually good at predicting that an existant trend will continue. But they’re not so good at spotting the turning points which is the most important part.

Posted by on February 22nd, 2012 at 8:09 am


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