Valuation & the Bond Yield

Are stocks undervalued? They certainly seem to be, especially relative to bonds. Very often in the past, falling bond yields were associated with rising valuation multiples. This time seems to be different. Or is it just a temporary divergence, and a great buying opportunity? Let’s analyze the data:

(1) The forward earnings of the S&P 500 dropped for the fifth week in a row through last Friday to $107.59 per share. This is the time weighted average of the latest consensus estimate for 2011 ($97.80) and for 2012 ($110.53).

(2) The forward P/E edged up to 10.7 from 10.5 the previous week. That’s not much above the previous low of 9.3 in December 2008, which was a 23-year low. Monday’s rally lifted the P/E to 11.0. That’s still well below 15.0, which is widely believed to be about the normal valuation multiple during normal times. Actually, using monthly data, the average forward P/E for the S&P 500 since the start of the data during September 1978 has been 13.6.

(3) Today’s charts compare the forward P/E to the 10-year Treasury bond yield and to expected inflation in the 10-year TIPS yield. The close positive correlation among these three variables since 2007 has been remarkable.

However, it isn’t surprising. Since 2007, the yield and expected inflation have fallen when the economic outlook seemed to be worsening as the financial crisis intensified. When the crisis seemed to be abating, yields and expected inflation rose. The same cycle of fear and relief that’s been behind the volatility in yields and expected inflation has been driving the stock market’s valuation of earnings.

In other words, lower bond yields are bad for stocks, while higher yields should be good for stocks. It’s not clear how Operation Twist might alter this relationship. It is the latest monetary stimulus program that reflects the Fed’s lack of confidence in the economy’s ability to grow without massive policy intervention. The problem is that investors have lost their confidence that such intervention is helping the economy. Indeed, some believe it is actually counterproductive.

I’m in that camp. Nevertheless, stocks are cheap. So I don’t see much more downside for the valuation multiple. However, it may take some time for it to move back up to its norm. That will happen when the financial crisis is finally behind us.