Stocks Cheap Versus Bonds


Evaluating the stock market based on historical price/earnings ratios, dividend yields, and yield spreads goes only so far. Stocks cannot be valued like bonds; partly because corporate earnings are volatile, equity investors need to look forward.

Still, such historical comparisons can provide perspective, especially with so many bears arguing that stocks are dangerously overvalued — and so many bulls justifying today's valuations with comparisons to today's low bond yields. Some highlights:

Price/earnings ratio. The S&P 500 Index trades at nearly 25 times trailing 12-month net earnings. That P/E is below the 20-year norm of 26 — a ratio inflated by P/Es above 100 in 2009, when earnings were depressed. The 40-year norm is 20. Today's P/E is higher than 60% of monthly observations over the past 20 years — and 78% of observations over the past 40 years.

Valuations seem more reasonable when looking at individual stocks. Excluding P/Es above 75 or below 0, the median trailing P/E of S&P 500 stocks is 19.5, about 7% above the 20-year norm of 18.3. About 40% of S&P 500 stocks have P/Es below 18, below the 20-year norm near 48%.

Dividend yield. The S&P 500 Index has an indicated dividend yield of 2.1% — above the 20-year norm of 1.8% but below the 40-year norm of 2.8%. Today's yield is higher than 79% of monthly observations over the past 20 years and 39% of observations over the past 40 years.

Some consider today's yield inflated, since dividends have grown faster than earnings in recent years. But the payout ratio (the percentage of profits being paid out in dividends) of 51% is nearly equal to 20-year and 40-year norms.

Earnings yields versus bond yields. The S&P 500 Index's trailing P/E of 25 equates to an earnings yield (earnings/price ratio) of 4.0% — quite low versus 40-year and 60-year norms but unusually high relative to what's available on risk-free assets. Today's earnings yield exceeds the yield on 10-year Treasury bonds by nearly 2.5%, compared to an average advantage of 0.3% over the past 60 years. Today's spread is higher than about 80% of monthly observations over the past 40 and 60 years.

Dividend yields versus bond yields. Comparing dividend yields and bond yields, stocks look even better. The S&P 500's yield is 0.5% higher than the 10-year Treasury yield. Over the past 60 years, the Treasury yield has exceeded the dividend yield by an average of 3.1%. Today's spread is more attractive than 97% of observations over the past 40 and 60 years.


Much of the market's overvaluation centers on the least-volatile stocks, and the typical stock looks cheaper than the capitalization-weighted S&P 500 Index. Still, there is no denying that stocks are expensive relative to historical norms.

Relative to bond yields, however, the S&P 500 Index appears quite cheap. All else equal, the 10-year Treasury yield would need to rise to 3.6%, up from today's 1.6%, for the spread between earnings yields and bond yields to match the 20-year norm.

Obviously, much depends on the outlook for bond yields. If yields jump because the global economy is gaining traction, the positive implications for corporate earnings could counter the likely compression of P/E ratios. But if yields jump because of inflation concerns or because central banks see bubbles developing in real estate or elsewhere, stock prices could take a substantial hit.

For now, watch the averages, bond yields, and inflation news. A move above the April high of 8,109.19 in the Dow Transports would be bullish, as it would signal that the majority money opinion expects better days ahead for economy. Our buy lists have 78% to 81% in stocks, though our equity exposure will increase with a close above 8,109.19.

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