Yesterday, amid the stock market carnage, I tweeted this:
Today I decided to take a closer look at general equity valuations because I believe most investors are currently overlooking a few key stats.
First, I must admit that while stocks may be cheaper (based on trailing 12-months earnings) than any other time during the past twenty or so years they are not as cheap as they have been at epic bottoms such as those seen during the 1974-1982 era:
However, to put this period into context, the yield on long bonds back then was three times higher than it is today. The chart below compares that yield over time to the earnings yield on the S&P 500 Index (the inverse of a price-to-earnings ratio):
It's clear from this chart that these yields have correlated pretty closely over that time. Of course, there are times when they diverge; the first big blue spike there is the 1974 bear market bottom.
Today, we are seeing a similar spike in the earnings yield versus the long bond yield indicating that investors are shunning equity earnings yields in favor of bond yields. In fact, the divergence is just about as wide as it was during that 1974 bottom.
The chart below plots the difference in the two yields (equity earnings yield – the long bond yield):
As a result, I would expect the managers of large asset allocation funds (such as endowments and public pensions) to be shifting capital from bonds into stocks at current levels. After all, it's clear that's where the value is.