Are U.S. Stocks Still Cheap?

In an August 6, 1979 article in Forbes, Warren Buffett said we can think of the stock market as a kind of bond with a fluctuating coupon. That coupon is the earnings yield of the stock market which we calculate by dividing the earnings of the market by its price. If the earnings yield of the stock market is materially higher than that of the bond market, it may indicate that stocks are cheap.

In a December 19, 2008 letter to the shareholders of Longleaf Partners, Mason Hawkins, along with the fund’s management team, asked the question, “How Cheap are U.S. stocks?” To provide an answer, they compared the 5-year average earnings yield of the S&P 500 with the yield of the 10 year U.S. Treasury. They then compared this ratio to that of past bear market lows.

I have adopted their format as one the tools I use to value the overall stock market. This is not about timing the market, but, rather, assessing whether it is under or overvalued.

On Tuesday, July 21, 2009, the S&P closed at 954.58. This gave the S&P an earnings yield of 6.75%, based on its trailing 5-year average earnings of $64.43.

This is 1.91 times the 3.53% yield of the 10 year U.S. Treasury, which gives the S&P a yield advantage of 3.22%

Here is how the ratio of 1.91 compares with other bear market lows:

October 4, 1974 – 1.4 (S&P yield advantage: 2.7%)

August 12, 1982 – 1.0 (S&P yield advantage: 0.4%)

October 19, 1987 – 0.7 (S&P yield advantage: -2.3%)

July 23, 2002 – 1.1 (S&P yield advantage: 0.4%)

It is interesting to note that on March 9, 2009, which was the low point for the S&P in the first half of 2009, the S&P’s earnings yield shot up to 9.86%. This gave the S&P a yield advantage of 7.36% over that of the 10 year U.S. Treasury, and made the ratio swell to 3.94.

Here is a spreadsheet of the data I used.

Tomorrow, I’ll compare the S&P’s earning yield with that of high quality corporate bonds.


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