Equities are close to the cheapest level ever relative to debt even after the S&P 500’s biggest first-quarter rally since 1998, according to the so-called Fed model, which compares the earnings yield for stocks with Treasury rates.
Profit for S&P 500 companies have represented 7.16% of the index’s price on average in 2012, or 5.13 percentage points more than yields on 10-year Treasuries, according to Fed model data compiled by Bloomberg. That compares with the average difference of 0.03 percentage points and the record high of 6.99 points when the bull market started in March 2009, according to data compiled by Bloomberg going back to 1962.
“This is a very attractive time for equities, especially relative to bonds,” Abby Joseph Cohen, the senior U.S. investment strategist at Goldman Sachs, said in a telephone interview on April 13. After three decades of declines, “it’s hard to see how interest rates are going to go down much more and stay there for a long period of time,” she said.
Cohen said she likes stocks with increasing dividends in groups such as technology. David Kostin, the firm’s chief U.S. equity strategist, recommends energy and technology companies.
Warren Buffett, the chairman of Berkshire Hathaway Inc. and the third-richest person in the Bloomberg Billionaires Index, said in February that low interest rates and inflation have made bonds “among the most dangerous of assets.”
The last time real yields were negative was from 1979 to 1980 when Fed Chairman Paul Volcker fought runaway inflation by raising borrowing costs. The same acceleration in consumer prices that Volcker targeted also pushed 10-year Treasury yields below the so-called core inflation rate at the end of 1970 and during 1974 to 1975. American consumer prices excluding food and energy rose 13.3% in May 1980, 310 basis points, or 3.1 percentage points, more than bonds.
During Eisenhower’s presidency, real yields were negative in 1958, according to the International Monetary Fund.
Fed Chairman Ben S. Bernanke has left the benchmark rate near zero since 2008 to spur inflation and lure investors into riskier assets as he tries to help restore the 8.7 million jobs lost during the recession that ended in 2009.
Bad for Stocks
“If you’re looking at real yields being zero, what that implies is the market doesn’t expect a whole lot of real economic growth,” Wayne Lin, a money manager at Baltimore-based Legg Mason Inc., said in a phone interview on April 12. His firm oversaw $643 billion as of March 31. “It’s negative for equities. Multiple expansion, earnings growth, all that is driven by economic growth.”
Morgan Stanley’s Parker said the economy has yet to prove it can grow without the Fed’s help, posing a risk to equities. The central bank’s attempt to eliminate the threat of deflation with unprecedented stimulus won’t boost the stock market forever, according to Parker, the New York-based U.S. equity strategist at the firm.