Soaring Stock Valuations No Big Deal to Powell Next to Bonds
(Bloomberg) -- To defend soaring equity markets against claims of overinflation, economists often cite a valuation methodology that adjusts stock prices for interest rates. The latest to do it is Jerome Powell.
In his press conference Wednesday, the Federal Reserve chairman said that relative to risk-free rates of return, a reference to Treasury yields, shares probably aren’t as overpriced as they appear at first blush. It makes sense Powell would cite the comparison -- it’s a version of something that over the years has come to be known as the Fed model.
“If you look at P/Es they’re historically high, but in a world where the risk-free rate is going to be low for a sustained period, the equity premium, which is really the reward you get for taking equity risk, would be what you’d look at,” Powell said.
The S&P 500’s earnings yield -- profit relative to share price -- is 2.5 percentage points higher than the yield on 10-year Treasury notes. The comparison, loosely labeled the Fed model, sits well above what the spread was before the burst of the internet bubble, when bonds yielded more than equities by that measure.
“The PE mafia hates his answer, but it is what it is,” Dennis DeBusschere, head of portfolio strategy at Evercore ISI, said in a note to clients. “Fighting that battle is like trying to convince an extreme partisan to change her position.”
A look at equity risk premium offers a very different picture than a plain look at the S&P 500’s price-earnings ratio. Currently, the stock benchmark is trading at 29 times trailing earnings. In 1999, that metric surpassed 30.
“Admittedly P/Es are high but that’s maybe not as relevant in a world where we think the 10-year Treasury is going to be lower than it’s been historically from a return perspective,” Powell said.
A Wall Street debate on equity valuations was explored in a Dec. 13 column by Bloomberg Opinion’s John Authers. Generally, Powell’s view was shared by Yale University professor Robert Shiller in an article earlier this month that says “equities will continue to look attractive, particularly when compared to bonds.”
But Albert Edwards, the often-skeptical strategist for Societe Generale SA, disagrees. In a note refuting Shiller, Edwards says that such framework assumes that all other things would stay constant in valuation models. In reality, Edwards says, lower returns tend to come with other developments, such as slower economic growth and volatile profit cycles, things that could depress valuations.
“U.S. equity valuations are a QE-fueled bubble waiting to burst,” Edwards wrote in a note last week.
Even Ed Yardeni, the economist who coined the term “Fed model” from a July 1997 report, has acknowledged its limitations given the Fed’s heavy involvement in setting interest rates nowadays.
If you look at history since 2000, the bond comparison has a spotty record. Stocks appeared to be relatively cheap going back that far, yet equities also suffered one of the worst bear markets in history from 2007 to 2009.
Over the stretch, when yields rose, stocks also tended to rise, rather than falling as the Fed model would suggest. The pattern exists because deflation has dominated market concerns and therefore higher rates have been greeted as a bullish sign for growth by equity investors, according to Ned Davis Research.
That’s not to say that the model is broken. From the 1970s to 1990s, the relationship between the two assets played out just like it would have envisioned. And that’s because at that time, inflationary forces prevailed and higher yields tended to lead to lower share prices for fear of Fed tightening.
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