The S&P 500 Index is Substantially Undervalued Relative To The 10-Year U.S. Government Bond

It has been my opinion for some time now that the S&P 500 index is substantially undervalued relative to the 10-year U.S. government bond, as I have previously discussed. I now have additional data to support my hypothesis.



The chart shown above (click on it to view an enlarged image of this chart) shows a plot of the trailing earnings yield of the S&P 500 from January 1979 through December 2005. The earnings yield is the inverse of the P/E ratio, i.e., it is the E/P ratio of the S&P 500. The chart also shows a plot of the yield on the 10-year-govt. bond during the same time period. All of the data plotted above is based on the end-of-month closing values of each of these securities every month from 1979 until 2005.

As shown, the 10-year-govt. bond yield was higher than the S&P 500 earnings yield for almost every month during the entire time period. The only times when it is lower is between (a) 1979 and 1980, and (b) between mid-2002 and today. During this time period, the average end-of-month trailing P/E ratio of the S&P 500 was 16.29, giving an earnings yield of 6.14%, and the average 10-year-govt. bond yield was 7.77%. Accordingly, on average, the 10-year-govt. bond yield was 1.64% higher than the earnings yield.

Therefore, one can deduce that when the 10-year-govt. bond yield was more than 1.64% larger than the S&P 500 earnings yield, it was, an average, a sign that the S&P 500 was overvalued relative to the 10-year-bond. Conversely, when the 10-year-govt. bond yield was less than 1.64% larger than the earnings yield, it was, an average, a sign that the S&P 500 was undervalued relative to the 10-year-govt. bond.

Currently, as of December 31, 2005, the S&P 500 trailing P/E ratio was 17.30, giving an earnings yield of 5.78%, and the 10-year-govt. bond yield was 4.39%. Accordingly, the earnings yield of the S&P 500 was 1.39% larger than the 10-year-govt. bond yield.

I view this as a very bullish sign that the S&P 500 is due to rally relative to the 10-year-govt. bond. As discussed above, the S&P 500 earnings yield was, on average, about 1.64% less than the 10-year-govt. bond yield from 1979-2005, but now it is currently 1.39% greater than the govt. bond yield! To correct this anomaly, the S&P 500 would have to undergo a tremendous rally relative to the 10-year-bond.

*In a previous post I discussed the relative valuations of the S&P 500 earnings yield versus the 10-year-govt. bond yield. The earnings yields discussed in the previous post were based on forward earnings estimates for the S&P 500, instead of the actual trailing earnings used above. I had to use the actual earnings for the current discussion because I was plotting historical earnings and did not know what the forward estimates were throughout this time period.