OPPORTUNITY KNOCKING
Well, take a look at this next chart. It’s the same as the one before, updated to the present... Isn’t it crazy – after 10 years of soaring stock prices – that stocks are still cheap based on this measure? You may not believe it... but I’m simply comparing the benchmark of interest rates (the 10-year U.S.
Stock Earnings Yield vs. Bond Yield
9%
8%
7%
6%
5%
Stock Earnings Yield
4%
3%
Bond Yield
2%
Source: Bloomberg
1992
1995
1998
2010 2007 2004 2001
2013
2016
2019
Now that you know all the “ingredients,” here’s how my stock market affordability indicator works... Whenever interest rates are high relative to the earnings yield, then stocks are expensive. And whenever the earnings yield is high relative to interest rates, then stocks are cheap. You can see these two yields in the above chart. And if you look closely, you’ll notice something interesting... Throughout history, the relationship between the earnings yield and interest rates has held up pretty well. When it gets out of whack, something big happens to push the relationship back into place. In late 1999 for example, bonds paid nearly 7% interest. But the earnings yield on stocks was around 3.5%. So stocks were a terrible deal in late 1999 relative to bonds. We all know what happened next... Stock prices crashed, and the earnings yield soared (remember, yields and prices move in
Treasury yield) to the benchmark of stock valuations (the price-to-earnings ratio, or P/E ratio for short). In order to compare apples to apples – and look at stock yields versus Treasury yields – I invert the P/E ratio. It still shows whether stocks are expensive or cheap... It’s just the E/P ratio instead of the P/E ratio. In finance, we call it the “earnings yield.” So, if the P/E ratio is 20, then the earnings yield is 5% (1 divided by 20).
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0% -25% -50% -75% -100% 25% 50% 75% 100%
Dot-Com Bubble 2000
Market Bottom 2009
2019 2016 2013 2010 2007 2004 2001 1998 1995 1992
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October 2019
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