Are Stocks Actually Cheap?

There's a debate brewing at The Fool and it involves the relationship between stocks and bond yields. And while some of it may seem a bit wonky, what it really boils down to is the age-old, and ever-important question: Are stocks cheap right now?

On one side of the debate we have Morgan Housel, who recently suggested that the fact that the dividend yield on the Dow Jones exceeds that of 10-year Treasuries means that stocks are a buy. On the other side, we have Alex Dumortier, who believes the relationship between stocks and bond yields is essentially meaningless.

So who's right? That's exactly what I was hoping to figure out.

Bringing out the big guns
To back up his thesis, Alex pointed me towards a paper from Cliff Asness, a hedge fund manager and phenomenally accomplished individual. Asness' paper basically debunks the so-called Fed model, which assumes that earnings yields and rates such as the 10-year Treasury should be roughly comparable.

While I don't agree with all of the conclusions that Asness comes to in the paper, I do think the most central point is right on the money. And that is that the Fed model in its basic form is very dangerous. Right now, for example, with 10-year Treasuries yielding 2.5%, the Fed model would assume that an equity market P/E of 40 would be reasonable. And that, my Foolish friends, is utter nonsense.

Yeah, but…
The problem is that even though it can be shown that the current earnings yield -- and similarly dividend yield -- versus the current Treasury yields have little predictive power over future stock returns, I ran some of my own regressions and found that it can be shown that the current earnings yield/bond yield differential is predictive of the relative returns of stocks versus bonds. That is, when the earnings yield exceeds bond yields, it's likely that the return on stocks will be better.

And this is important because investors do face a choice and they do have opportunity costs of investing in stocks, bonds, or nothing at all. In other words, relative valuations do matter.

But that doesn't mean we can get lazy and assume that relative valuations are all that matter. I would argue -- as Morgan has in the past -- that bonds are currently at bubble levels. That doesn’t necessarily preclude stocks from being overvalued as well. If the major indices were currently sporting P/E's of 30, I'd have no problem at all keeping most of my investable assets in cash and waiting for better valuations.

But if bonds are overvalued, it shouldn’t be all that surprising, or be considered silly, if investors are willing to accept lower expected returns -- a.k.a. higher valuations -- from stocks. When your primary choices are bonds, equities, or cash, somewhat below average stock returns can be a better choice than cash's non-returns.

Well then, what's the answer?
So, you're probably thinking, are stocks cheap or what?

Heading back to Morgan's article, he highlights specifically that the dividend yield on the Dow Jones Industrial Average is above the yield on 10-year Treasuries. Comparing the dividend yield to bond yields is similar to using the earnings yield, but I prefer it because it's a higher hurdle, as most companies pay out only a fraction of their earnings in the form of dividends. So this tips us off to the possibility that Dow stocks are attractive, but we've got to look closer to find out if that's true.

On an equal-weighted basis, the current trailing P/E on the Dow is 13.8 and the average forward P/E is 13.4. On closer inspection, the individual issues within the Dow appear to confirm that we have some pretty attractive stocks among that group:

Company

Trailing P/E

Forward P/E

Dividend Yield

Pfizer (NYSE: PFE  )

16.9

7.9

4.1%

Hewlett-Packard (NYSE: HPQ  )

10.8

8.4

0.8%

Chevron

9.5

8.5

3.6%

The Travelers Companies

7.1

9.5

2.7%

Microsoft

11.4

10.6

2.6%

Exxon Mobil (NYSE: XOM  )

12.8

10.8

2.9%

JPMorgan Chase

10.3

10.9

0.5%

Merck (NYSE: MRK  )

10.4

11.1

4.1%

IBM (NYSE: IBM  )

12.1

11.9

1.9%

AT&T (NYSE: T  )

13.4

12.3

5.9%

Cisco (Nasdaq: CSCO  )

15.9

12.8

0%

Source: Capital IQ, a Standard & Poor's company.

On an individual basis, I'd want to dig in even further to try to determine things like whether Pfizer and Merck will be able to cope with expiring drug patents, at what pace Exxon will be adding new reserves, and if AT&T can prove that it has juice beyond the iPhone. But on a group basis the signs are pointing toward the Dow being buyable. Not that this is particularly shocking to me since I've been eyeing blue chip bargains for some time now.

If we move from the Dow to the S&P, we can no longer say that that the dividend yield of the entire index exceeds the 10-year Treasury rate. There are, however, stocks within that index that have tantalizing valuations -- many of them in the blue chip family.

On an absolute basis, "cheap" would overstate the current case for stocks. However, there are a fair number of stocks right now that we could say are attractive on an absolute basis and a screaming bargain on a relative basis.

Keep it simple, but not too simple
In the end if there's anything that I think investors can take away from this controversial issue, it's that there's always danger in relying on any one figure to determine whether you've found an attractive investment. Do some digging, come at it from a few different angles, and if it's as attractive as you think it is, you'll likely see all of your data points converge.

Have your own thoughts on the great yield debate? Head down to the comments section and share your thoughts.

Sick of theoretical banter and ready for some actual stock ideas? Check out these five dividend growth stocks.

Microsoft and Pfizer are Motley Fool Inside Value selections. Chevron is a Motley Fool Income Investor recommendation. The Fool has written calls (bull call spread) on Cisco Systems. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Exxon Mobil, International Business Machines, and Microsoft. Try any of our Foolish newsletter services free for 30 days.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Fool contributor Matt Koppenheffer owns shares of AT&T, but does not own shares of any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool’s disclosure policy assures you no Wookies were harmed in the making of this article.


Read/Post Comments (12) | Recommend This Article (39)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 29, 2010, at 5:06 PM, goalie37 wrote:

    The relationship between earnings yields and bond yields is only relevant when you have a somewhat rational bond market.

    Stocks right now are neither overpriced nor underpriced right now, because not all stocks are the same. Is AMZN a bargain at 65x earnings? Is XOM overpriced at 11x earnings? These are both terrific companies whose stocks are not trading in a similar fashion.

  • Report this Comment On September 29, 2010, at 6:34 PM, TMFKopp wrote:

    @goalie37

    "The relationship between earnings yields and bond yields is only relevant when you have a somewhat rational bond market."

    See, I'm not sure that I agree with that. Bond returns still represent an opportunity cost when you decide to invest in stocks. And when bond yields are low (prices high) investors should be willing to pay a bit more (accept a somewhat lowered return) from stocks.

    Matt

  • Report this Comment On September 29, 2010, at 7:37 PM, killerpants wrote:

    @TMFKopp I agree about there being an opportunity cost to invest in bonds. However, bonds and stocks are not the only investment options, so the earnings yield is not necessarily the opportunity cost. That's why I think the point to take away from goalie37 is that both markets can be simulatenously overpriced, or individual segments of either market can be overpriced.

    The earnings yield/bond yield differential probably shouldn't be used as a justification for buying stocks when 10-year bond yields are absurdly low and essentially have only one way to go. There are other asset classes! In the event that stocks and bonds both fall, cash or gold will look like where the geniuses were.

    There's not much evidence that either stocks or bonds are a good value right now on average, but that doesn't mean there are not individual stocks or even industries that are undervalued. Even though most stocks have run up in the off-and-on rally since March 2009, all have not run up equally.

    One way to generate some returns might be to use a covered call strategy or low-leverage out of the money bull-put strategy for the short-term.

  • Report this Comment On September 29, 2010, at 9:24 PM, TMFKopp wrote:

    @killerpants

    "However, bonds and stocks are not the only investment options"

    True, and when you bring in other options it complicates the situation a bit more, but it basically stays the same.

    So if we're talking about an environment where now you're looking at, say, bonds, stocks, and gold, if bonds are offering low expected returns, then you're going to be willing to invest in gold and/or stocks and accept somewhat lower returns from each than you "normally" would (in quotes because what's "normal" anyway? :) ).

    Now if both bonds and stocks are offering low expected returns then in this example you're going to look towards gold. And with bleak options confronting you in the other two assets you'd be willing to accept somewhat lower returns on gold and still be willing to put your money there. Why? Because your opportunity costs are low.

    Of course the above is just an illustration, not what I actually believe. If you ask me, bonds are a terrible investment right now, while stocks are not dazzlingly cheap, but are a much better option than bonds.

    Gold, in my mind, is a poor investment and it would be a bad idea to put more that a small amount of your portfolio in it. Industrial metals and other _useful_ natural resources are another story, but I'd rather find good, cheap companies producing them than buy the commodities directly.

    Bottom line though, you're basically saying the same thing -- there's a such thing as opportunity cost and when one asset class promises lackluster returns it lowers the bar to invest in other asset classes.

    Matt

  • Report this Comment On September 30, 2010, at 12:25 AM, gman5556 wrote:

    It is far too general of a statement to make. You can't just say "stocks are too expensive" or "stocks are really cheap right now". Models like the Fed and others similar to it place too heavy of a bias on assumptions which can be skewed too easily simply to fit whatever the author had in mind in the first place. The stock market as a whole is far too complex, to a level beyond human comprehension/intelligence. You have to look at all of the tiny pieces that make up the giant puzzle to be able to make such a claim for or against, which is in itself an impossible task. There will always be mis-priced securities and there is no model or formula that will provide the right direction to look in. You have to look at each security/company completely separate from the others. There is no magic formula or model. There is no combination of macroeconomic events that lead the way to the right answer or where to look.

    But this is just my opinion and to be honest I threw away all of my financial economics books because they were no more useful to me in life outside of a chalk board than a paper weight. I just kept the accounting books. And I don't mean to be rude or prejudice towards hedge fund managers but honestly they would be the very last group of people I would trust about anything.

  • Report this Comment On September 30, 2010, at 12:44 AM, goalie37 wrote:

    @TMFKopp - Although our comments were opposite, I think our bottom line is the same. Bonds are an absolutely terrible place to put money right now, and stocks only seem appealing in comparison.

    I stumbled on to the earnings yield versus bond yield by accident when I first started investing, during the dot com craze. At the time, bonds were yielding 5-6%, while many stocks were yielding 1% or less (for those stocks that actually had earnings.)

    As to whether this formula has merit, there can be a valid case for both. Opportunity cost is true based upon simple mathematical logic, so I do not disagree with you there. On the other side, I do not need to look at the earnings yield of stocks to know that 2.5% for a 10 year bond is a bad idea, just as a 1% earnings yield on a stock in 1999-2000 was equally ridiculous.

    Where I think common ground can be met is in the spread between the earnings yield and the bubble-like yields in bonds. It is not a matter that stocks yield more, but that stocks yield several hundred basis points more. America's largest corporation, Exxon Mobil (XOM) has an earnings yield of 8.4%. This is substantially higher than the bond yield, which would make the stock cheap in your view. It would also be cheap in my view because 8.4% trumps bonds in almost any market.

  • Report this Comment On September 30, 2010, at 12:47 AM, topsecret09 wrote:

    NO !

  • Report this Comment On September 30, 2010, at 1:32 AM, TMFKopp wrote:

    @goalie37

    "On the other side, I do not need to look at the earnings yield of stocks to know that 2.5% for a 10 year bond is a bad idea, just as a 1% earnings yield on a stock in 1999-2000 was equally ridiculous."

    I don't have the book in front of me so I won't get the quote quite right, but I believe it's in The Intelligent Investor that Graham writes something to the tune of: "You don't need to know that a man is actually 400 pounds to be able to say that he's fat."

    "America's largest corporation, Exxon Mobil (XOM) has an earnings yield of 8.4%. This is substantially higher than the bond yield, which would make the stock cheap in your view."

    Just to be clear, I _don't_ subscribe to the Fed model. I think dividend yields versus bond yields can be a pointer, but I would say XOM is interesting for the same reason you do -- I don't need any complex math to know that an earnings yield like that is attractive.

    Matt

  • Report this Comment On September 30, 2010, at 3:50 AM, exdividendday wrote:

    I believe that stocks are cheap in relation to bonds. Ii researched the 10 cheapest large caps on American stock exchanges. Here are my results:

    http://long-term-investments.blogspot.com/2010/09/10-cheapes...

    The average dividend yield amounts to 5.82 percent and price earnings ratio is 9.11.

  • Report this Comment On September 30, 2010, at 5:02 AM, TMFUltraLong wrote:

    The problem here is that bond prices are looked at right now as if they are in a bubble - they aren't. High bond prices and low yields are just a reaction to the overwhelming unwillingness of investors to take on any risk whatsoever and it's a psychological response I'd expect to stick around for a while. A bubble is just a swing-trend, this is something much deeper in the bond market.

    I mean if you told me five years ago that traders would be willing to happily accept 2.5% on a 10-year note I'd have clubbed you over your head and taken your lunch money. Today, this is absolutely the case and it will probably remain so for quite some time. I really don't see the 10-year having any hope of trading about 3.3% in the next 36 months and feel it could potentially drop as low as 2.05% before the fall is abaited with a rebound.

    Does this mean bonds are a poor idea? Not really, they still are your safest investment as long as the Fed is abusing our money supply and keeping a "cap-off the cookie-jar" approach to the economy. Inflation is non-existant to my dismay at the moment and you're going to churn a 1.5-2% real world gain from a 10-year bill right now, but inflation likely won't be this low 4-6 years from now.

    Stocks on the other hand give you greater risk-reward but are they really cheap? They're cheap compared to the 2000 bubble, but hindsight is so 20-20 they say! They're the more interesting necessary evil. I think you need to hedge yourself with some bonds and some short/put positions in stocks as well.

    Does that really answer anything? Not really but my cat loves to hear me type....

    UltraLong

  • Report this Comment On October 02, 2010, at 9:48 PM, KZMike wrote:

    You gotta love reading these comments. . . ALL very well thought out, way above my level of expertise [so I am learning much], none of the trash talk I've seen on other sites. . . AND . . .

    . . . my cat[s] also love to hear me type. . .

  • Report this Comment On October 05, 2010, at 10:03 AM, eigenvalue100 wrote:

    I searched the EconLit data base for the "Fed model" and found 15 entries after C. Asness' article. I will just mention a few: 'Inflation and the stock market: Understanding the "Fed Model", by G. Bekaert and E. Engstrom, Journal of Monetary Economics, April 2010; from the abstract: The so-called Fed model postulates that the dividend or earnings yield on stocks should equal the yield on nominal Treasury bonds,or at least that the two should be hihgly correlated. ... This positive correlation is often attributed to the fact that both bond and equity yields comove strongly and positively with expected inflation."

    'The Fed Model: The Bad, the Worse, and the Ugly' J. Estrada, Quart. Rev of Econ and Fin, May 2009. From the intro: 'Most practitioners like simple models. .. Some investors are led to believe that by simply comparing two numbers (..) they can easily determine whether the stock market is mispriced. Even worse, some are even led to believe that such a simple comparison is a shortcut to abnormal returns.'

    As hard as it is to uncover the hidden assumptions underlying a theoretical model, it is harder yet to apply the model to the "real world", given the great number of confounding factors, such as inflation expectations, money illusions, uncertainty about growth prospects, variation in risk aversion and the effects of monetary and fiscal policy, to gauge deviations from relations that may hold in 'equilibrium'.

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