Another day, another set of nightmare headlines from Europe. The stock market has fallen another 200-plus points, measured by the Dow Jones Industrial Average. The flight to Treasuries continues apace, with yields on the 10-year bond almost down to 1.5%.
What will happen next? Is it time to panic yet?
Long-term followers of this blog and our firm’s other communications will know the answer to the last question — it never pays to panic. They will probably also suspect the answer to the first question, which is that nobody has any demonstrated ability to make useful short-term predictions, and focusing on the short term reliably leads to bad decisions — like panicking and selling.
So instead, consider the following chart, which takes a very long-term look at the relationship of the earnings yield on the S&P 500 to the coupon yield on the 10-year Treasury bond.
As you can see, the yields of the two asset classes have been quite closely related since roughly 1960. One notable exception was the bear market of 1973-74, which was in retrospect a great buying opportunity for stocks.
The following chart makes the relationship a bit clearer, by turning the two yields into a ratio.
As you can see, measured by earnings yield the S&P is the cheapest it has been, in relationship to bonds, since the early 1950s. The cheapest it has been in my lifetime, in other words. (By the way, the data set here stops at December 2011. If we carried it through today, the ratio would be well north of 4x. I didn’t do that because my research assistant is in a car driving home to Indiana.)
Looking back at the purple line on the top chart, I’d argue that stocks are not very cheap in absolute terms. We;’re back about where we were in 1990, a good but not spectacular time to buy equities.
But in relation to bonds, stocks are crazy-cheap. And since stocks are fairly valued, that really means that bonds are crazy-expensive.