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:

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.