I wrote a post in February 2006 in which I argued that the S&P 500 was undervalued. Since then, the S&P 500 has risen from about 1283 to 1422, a return of 10.83%, excluding dividends. This is a strong gain and I think that the S&P 500 has further to go. Relative to bonds, the S&P 500 still appears to be undervalued.
According to Standard & Poor's, the projected reported earnings through 12/31/07 for the sum of the components of the S&P 500 is about $89.10/share. As discussed above, the S&P 500 index currently trades at about 1422. Accordingly, the forward P/E ratio of the S&P 500 index is about 15.96* (1422/$89.10). This is slightly higher than the historical P/E ratio of around 14-15. However, bonds are still more richly valued than their historical averages. Other asset classes such as real estate and commodities are also richly valued right now and have been for several years. As I wrote last February, it seems inevitable that stocks will eventually catch up to the performance of these other asset classes.
Stocks have been weighed down over the past couple years in large part due to high energy prices and a FED that had been steadily raising short-term interest rates. However, consumer price inflation is still low and bonds are expensive relative to historical averages. The yield on the 10-yr US bond is currently about 4.88%. The earnings yield on the S&P 500 based on estimated 2007 earnings* is about 6.27% (i.e., the inverse of the 15.96 P/E ratio). The earnings yield on the S&P 500 is therefore about 1.45% higher than the 10-yr bond yield. This is still a large disparity and will probably shrink over the next few years as the S&P 500 outperforms the 10-yr bond.
2007 should continue to be a good year for the S&P 500. The S&P 500 probably won't increase in value every month, but even after accounting for a pullback or two this should be a good year nevertheless.
* I used estimated "as reported" earnings in calculating the 2007 estimated earnings. Many stock market analysts use estimated "operating earnings" in calculating forward P/E ratios. The "as reported" earnings account for miscellaneous supposedly non-recurring "one-time" charges and expenses deducted from operating earnings. The "as reported" earnings provide a more realistic estimate of earnings because such miscellaneous non-recurring "one-time" charges and expenses occur every single year. It seems disingenuous to not factor them into the calculation of the forward P/E ratio.
Showing posts with label bond yield. Show all posts
Showing posts with label bond yield. Show all posts
Saturday, January 27, 2007
Tuesday, February 21, 2006
February 2006 Update - The S&P 500 Index Is Still Undervalued
I wrote a post last November in which I argued that the S&P 500 was undervalued. Since then, the S&P 500 has risen 5.16%, from about 1220 to 1283. This is a pretty good gain, but I think that the S&P 500 has further to go. Relative to bonds, the S&P 500 is still undervalued and due for more gains.
According to Standard & Poor's, the projected reported earnings through 12/31/06 for the sum of the components of the S&P 500 is about $79.30/share. As discussed above, the S&P 500 index currently trades at about 1283. Accordingly, the forward P/E ratio of the S&P 500 index is about 16.18 (1283/$79.30). This is slightly higher than the historical P/E ratio of around 14-15. However, bonds are much more richly valued than their historical averages. Moreover, other asset classes such as real estate and commodities are also richly valued right now. It therefore seems inevitable that stocks will eventually catch up to the performance of these other asset classes.
Stocks have been weighed down over the past year in large part due to high energy prices and a FED that has been steadily raising short-term interest rates. However, consumer price inflation is still relatively low and bonds are expensive. The yield on the 10-yr US bond is currently about 4.56%. The earnings yield on the S&P 500 based on estimated 2006 earnings is about 6.18% (i.e., the inverse of the 16.18 P/E ratio). Therefore the earnings yield on the S&P 500 is about 1.62% higher than the 10-yr bond yield. This is large disparity and is certain to shrink over the next few years as the S&P 500 outperforms the 10-yr bond.
I believe that 2006 will continue to be a good year for the S&P 500. The S&P 500 probably won't increase in value every month, but even after accounting for a pullback or two this should be a good year nevertheless.
According to Standard & Poor's, the projected reported earnings through 12/31/06 for the sum of the components of the S&P 500 is about $79.30/share. As discussed above, the S&P 500 index currently trades at about 1283. Accordingly, the forward P/E ratio of the S&P 500 index is about 16.18 (1283/$79.30). This is slightly higher than the historical P/E ratio of around 14-15. However, bonds are much more richly valued than their historical averages. Moreover, other asset classes such as real estate and commodities are also richly valued right now. It therefore seems inevitable that stocks will eventually catch up to the performance of these other asset classes.
Stocks have been weighed down over the past year in large part due to high energy prices and a FED that has been steadily raising short-term interest rates. However, consumer price inflation is still relatively low and bonds are expensive. The yield on the 10-yr US bond is currently about 4.56%. The earnings yield on the S&P 500 based on estimated 2006 earnings is about 6.18% (i.e., the inverse of the 16.18 P/E ratio). Therefore the earnings yield on the S&P 500 is about 1.62% higher than the 10-yr bond yield. This is large disparity and is certain to shrink over the next few years as the S&P 500 outperforms the 10-yr bond.
I believe that 2006 will continue to be a good year for the S&P 500. The S&P 500 probably won't increase in value every month, but even after accounting for a pullback or two this should be a good year nevertheless.
Friday, January 20, 2006
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.
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.
Monday, January 02, 2006
Strategy for Making Money Off The Price Disparity Between Stocks and Bonds
Back in November I wrote an article for this blog about the FED Model. In that article I mentioned that the P/E ratio of the S&P 500 was about 15.72 back then, resulting in an earnings yield (i.e., the inverse of the P/E ratio) of about 6.36%. The yield on the 10-year bond, on the other hand, was about 4.564%, resulting in an historically high risk premium (i.e., the difference between the earnings yield and the 10-year bond yield) of about 1.796%.
I checked the Standard & Poor's website today to see if the earnings estimates had changed since November. According to Standard & Poor's, the 2006 earnings projections on the S&P 500 have been slightly reduced to $76.80. As of the December 30, 2005 market closing, the S&P 500 was trading at 1248. Accordingly, the earnings yield on the S&P 500 is now about 6.154% (i.e., 1248/$76.80). Meanwhile, the 10-year bond yield has fallen to 4.395%, resulting in a risk premium of about 1.795%.
Risk premiums of well over 1% are historically very large. The average risk premium between 1994 and 2003 was about 0.11%. Accordingly, there is a strong likelihood that the current risk premium will eventually shrink to a much lower level.
To profit off this current price discrepancy between bonds and stocks and the inevitable shrinking of this risk premium, I recommend selling short shares of the iShares Lehman 20+ Year Treasury Bond ETF (symbol: TLT), and using the proceeds from the short sale to purchase shares of the S&P 500 Depository Receipts ETF (symbol: SPY).
I implemented this strategy myself on Friday, December 30th. Specifically, I sold short 25 shares of TLT at $91.9068/share and established a long position of 18 shares of SPY at $124.8388. My commissions were $5 on each transaction through my Ameritrade Izone account.
After shorting the shares of TLT, I received $2292.67 net of commissions. Including commissions, it cost a total of $2252.10 to purchase the shares of SPY. After these trades, my account looks like this:
-25 shares of TLT
+18 shares of SPY
$40.57 leftover cash from the short sale
I will post monthly updates to let everyone know how well this long-short hedge is performing.
I checked the Standard & Poor's website today to see if the earnings estimates had changed since November. According to Standard & Poor's, the 2006 earnings projections on the S&P 500 have been slightly reduced to $76.80. As of the December 30, 2005 market closing, the S&P 500 was trading at 1248. Accordingly, the earnings yield on the S&P 500 is now about 6.154% (i.e., 1248/$76.80). Meanwhile, the 10-year bond yield has fallen to 4.395%, resulting in a risk premium of about 1.795%.
Risk premiums of well over 1% are historically very large. The average risk premium between 1994 and 2003 was about 0.11%. Accordingly, there is a strong likelihood that the current risk premium will eventually shrink to a much lower level.
To profit off this current price discrepancy between bonds and stocks and the inevitable shrinking of this risk premium, I recommend selling short shares of the iShares Lehman 20+ Year Treasury Bond ETF (symbol: TLT), and using the proceeds from the short sale to purchase shares of the S&P 500 Depository Receipts ETF (symbol: SPY).
I implemented this strategy myself on Friday, December 30th. Specifically, I sold short 25 shares of TLT at $91.9068/share and established a long position of 18 shares of SPY at $124.8388. My commissions were $5 on each transaction through my Ameritrade Izone account.
After shorting the shares of TLT, I received $2292.67 net of commissions. Including commissions, it cost a total of $2252.10 to purchase the shares of SPY. After these trades, my account looks like this:
-25 shares of TLT
+18 shares of SPY
$40.57 leftover cash from the short sale
I will post monthly updates to let everyone know how well this long-short hedge is performing.
Thursday, November 10, 2005
The "FED Model" theory of equity valuation
The "FED model" is a popular yardstick for judging whether the stock market is fairly valued. This term was coined by Prudential Securities strategist Ed Yardeni after a Fed report to Congress in July 1997 suggested the bank was following it.
The FED model compares the yield of the 10-yr govt bond to the "earnings yield" of the S&P 500. The "earnings yield" is defined as the inverse of the forward P/E ratio of the S&P 500. As of the market close today the S&P 500 is trading at 1230.96 and the projected earnings for 2006 of the components of the index are $78.30. The forward P/E ratio for the S&P 500 is therefore about 15.72 (1230.96/$78.30). The inverse of the forward P/E ratio is E/P, known as the earnings yield. In this case, (1/15.72) is .0636, or 6.36%. As of market close today, the yield on the 10-yr govt. bond was 4.564%.
In theory, the yield on the 10-yr bond is equivalent to the different between the earnings yield and the risk premium (i.e., because stocks are riskier than bonds the earnings yield should ordinarily be less than the yield on the 10-yr bond). In this case, 4.564% = 6.36% - Rp (risk premium). In this case, Rp is 1.796%. Between 1994 and 2003, the average risk premium was 0.11%. Therefore, the current Rp of 1.796% is a very bullish sign and signals that it's probably a good time to buy.
During the stock market bubble, the risk premium was around -2% or worse - i.e., investors bid up stocks to great highs because stocks were actually viewed as being less risky than bonds. Today, on the other hand, investors are completely shunning stocks and invest their money in bonds instead.
CAVEATS
Although the FED model is useful, it does have its flaws. For example, the earnings yield is based on projected earnings, and it's always possible that the economy could go south and those projections will not be met. Moreover, this model only addresses the relative (not absolute) valuations of stocks and bonds. Stocks do not necessarily have to rise for Rp to decrease; instead, stocks could stagnate while bonds decrease in value.
The FED model compares the yield of the 10-yr govt bond to the "earnings yield" of the S&P 500. The "earnings yield" is defined as the inverse of the forward P/E ratio of the S&P 500. As of the market close today the S&P 500 is trading at 1230.96 and the projected earnings for 2006 of the components of the index are $78.30. The forward P/E ratio for the S&P 500 is therefore about 15.72 (1230.96/$78.30). The inverse of the forward P/E ratio is E/P, known as the earnings yield. In this case, (1/15.72) is .0636, or 6.36%. As of market close today, the yield on the 10-yr govt. bond was 4.564%.
In theory, the yield on the 10-yr bond is equivalent to the different between the earnings yield and the risk premium (i.e., because stocks are riskier than bonds the earnings yield should ordinarily be less than the yield on the 10-yr bond). In this case, 4.564% = 6.36% - Rp (risk premium). In this case, Rp is 1.796%. Between 1994 and 2003, the average risk premium was 0.11%. Therefore, the current Rp of 1.796% is a very bullish sign and signals that it's probably a good time to buy.
During the stock market bubble, the risk premium was around -2% or worse - i.e., investors bid up stocks to great highs because stocks were actually viewed as being less risky than bonds. Today, on the other hand, investors are completely shunning stocks and invest their money in bonds instead.
CAVEATS
Although the FED model is useful, it does have its flaws. For example, the earnings yield is based on projected earnings, and it's always possible that the economy could go south and those projections will not be met. Moreover, this model only addresses the relative (not absolute) valuations of stocks and bonds. Stocks do not necessarily have to rise for Rp to decrease; instead, stocks could stagnate while bonds decrease in value.
Wednesday, November 09, 2005
The S&P 500 index is undervalued
The P/E ratio of the S&P 500 is near a 10-year low. According to Standard & Poor's, the total reported earnings through 9/30/05 for the sum of the components of the S&P 500 was about $67/share. As of today, the S&P 500 index trades at about 1220. Accordingly, the trailing P/E ratio of the S&P 500 index is about 18.21 (1220/$67). The last time the trailing P/E ratio was this low was 10 years ago, at the end of 1995 when it was about 18.14 at the end of the Dec. 1995 quarter.
While the trailing P/E is attractive right now, the forward P/E looks even better. Standard & Poor's projects the earnings on the index for 2006 to be about $78.30, giving a forward P/E ratio of about 15.58 (1220/$78.30).
Is this a "buy" signal? I sure think so. Stocks have recently been weighed down by high energy prices and a FED that has been steadily raising short-term interest rates. However, consumer price inflation is still relatively low by historical standards. Moreover, relative to bonds, stocks look extremely attractive. The yield on the 10-yr US bond has recently risen sharply to 4.67%. In other words, despite the recent rise in bond yields, they are still priced as though there is no heavy inflation on the horizon.
Accordingly, I am led to the conclusion that stocks are due for a strong rally. Although corporate profits have been strong for several years now, stocks haven't done much since their strong surge in 2003. So I think that a rally is long overdue. It would not surprise me to see a 30% year-over-year rally in the S&P 500.
While the trailing P/E is attractive right now, the forward P/E looks even better. Standard & Poor's projects the earnings on the index for 2006 to be about $78.30, giving a forward P/E ratio of about 15.58 (1220/$78.30).
Is this a "buy" signal? I sure think so. Stocks have recently been weighed down by high energy prices and a FED that has been steadily raising short-term interest rates. However, consumer price inflation is still relatively low by historical standards. Moreover, relative to bonds, stocks look extremely attractive. The yield on the 10-yr US bond has recently risen sharply to 4.67%. In other words, despite the recent rise in bond yields, they are still priced as though there is no heavy inflation on the horizon.
Accordingly, I am led to the conclusion that stocks are due for a strong rally. Although corporate profits have been strong for several years now, stocks haven't done much since their strong surge in 2003. So I think that a rally is long overdue. It would not surprise me to see a 30% year-over-year rally in the S&P 500.
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