Wednesday, October 10, 2012

Winston Churchill and Today's Markets

Winston Churchill once famously said that "democracy is the worst form of government except all of the others that have been tried."

Paraphrasing Churchill's comments, in a different context, stocks today are modestly overvalued except when compared to all of the other alternatives.

Ned Davis of Ned Davis Research (NDR) this morning points out that the median S&P 500 P/E ratio was 17.5 at the end of September. 

As Mr. Davis writes:

That is 6.0% above 'fair value' based on the median of 16.5 P/E going all the way back to 1964.  I like median P/Es because they leave out a lot of questionable earnings reports.  Based upon median P/Es, we are very mildly overvalued.

Davis goes to examine some other traditional valuation metrics, and many seem to tell roughly the same story:  The stock market appears mildly overvalued, especially with the prospect of upcoming gloomy corporate earnings season.

However, compared to other classes of investments - bonds and cash - stocks scream out as wildly attractive.

According to NDR, the earnings yield of the S&P is 6.05%.  NDR's interest rate composite (average of Treasury Bill yields, 10-year Treasury yield, and Moody's Baa Corporate Yield) was 2.15% as of last Friday.

The ratio of the earnings yield of the stock market relative to bonds is 280, which is the widest it has been going back to 1967.

Deutsche Bank agrees with NDR, noting in their work that the gap between the earnings yield on stocks relative to the Treasurys has not been this wide since the early 1980's.

In other words, while there is plenty to be worried about in the global economy, stocks relative to just about every other asset class screen at relatively attractive levels.

Vanguard founder Jack Bogle was interviewed on CNBC on Monday, and also agrees that stocks are the place to be for investors with a longer term time horizon:

There’s up to a 90 percent chance that stocks will post greater returns than bonds over the next 10 years, Vanguard Group co-founder John “Jack” Bogle told CNBC on Monday. 

 “I think the odds that stocks will give a higher return than bonds over the next decade are probably 85 to 90 percent,” he said on “Fast Money.”

“The fundamentals are that bonds are yielding maybe 2 ½, 3 percent if you throw in some corporates, and stocks are yielding 2.2 percent in the S&P [.SPX  1441.48  ---  UNCH    ],” he added. “Yet the S&P stocks are going to have earnings growth. There’s nothing extra the government can do or the bond issuer can do other than pay the agreed-upon coupon.”