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Stocks: Mind the "Relative Trap"

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Stocks fell for the second day in succession, with the Dow Jones Industrial Average (DJINDICES: ^DJI  ) and the broader S&P 500 (SNPINDEX: ^GSPC  ) losing 0.4% and 0.3%, respectively.

Writing in the Financial Times yesterday, PIMCO co-chief investment officer Mohamed El-Erian observed [sign-up may be required]:

"The investment recommendations made by many financial commentators are now dominated by cross-asset class relative valuation rather than the fundamentals of the investment itself."

The trouble with relative valuation is that if one is a long-only investor, rather than a long/short arbitrageur, it assumes that the benchmark asset you're using to value other assets is itself properly valued. U.S. Treasury bonds are the ultimate benchmark asset, so in a zero-interest-rate environment in which Treasury yields -- the keystone of relative valuation -- are near historic lows, that could be a dangerous assumption.

Starvation yields have revived the "Fed model," which seeks to assess whether stocks are fairly valued by comparing their dividend yield with the Treasury yield. When the S&P 500's dividend is yield lower than the benchmark Treasury yield -- as has been the case for some time now -- the model indicates that stocks are cheap. Never mind that the Fed model's predictive value with regard to future stock returns is weak, it's a prime example of what financial economist Andrew Smithers calls "stockbroker economics": With record low bond yields, stocks can't look anything other than cheap (hence the stockbroker's recommendation: "Buy 'em.")

Two valuation indicators that have shown significant predictive value, the Tobin's q ratio and the cyclically adjusted price-to-earnings ratio, which uses a trailing average of 10-year real earnings per share, suggest stocks are somewhat overvalued. This doesn't mean investors shouldn't own any, but they should be prepared to earn returns below the historical average. Last month, Rob Arnott, the CEO of Research Affiliates, told my colleague Morgan Housel he expects the S&P 500 to deliver a 4% annualized return over the next 10 to 20 years. Investors who are looking to earn 10% a year on their stocks need to mind the relative trap and the "return gap" it could be masking.

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