Stock Market Valuation

Some traders I know think the US stock market is overvalued. The argument goes something like this: Volatility is very low (the VIX is slightly over 10%). This means that the risk premium is low; everyone is too complacent. If anything negative should occur, the market will put a more reasonable risk premium in and thus the selldown. I don't agree; I think they are confusing risk with volatility. The chart to the left is one reason why (click on the chart for a larger image).....

Over the years, I've found it impossible to get a hard DCF-type number to value the market. Earnings are pretty visible for a couple of years or so, but beyond that it's tough. You wind up having the result dominated by whatever terminal value you assume, and that is true guesswork. So I feel I do better if I look at relative value. The most important relative value is stocks vs. bonds.

The chart is a graph of the so-called Fed Model basis year-end since 1960. The x-axis is the yield on 10-year treasuries, and the y-axis is the earnings yield on the S&P500 (This is the inverse of the market P/E ratio.). One would expect an upward-sloping cloud of points for this and that is exactly what you get . Now what does this say about the risk-premium in the stock market. I would argue that when a point is above the upward-sloping cloud, there is a high risk premium. At that point investors are only willing to buy the market if the earnings yield is far above the 10-year note yield. Such points were seen in 1974, 1979 and 1982. Not surprisingly, they were also good buying opportunities. The points below the cloud, including 1992 and 1999-2001 had low risk premia and were bad times to buy.

Right now the market is in the high part of the cloud, indicating a slightly undervalued stock market. This is a big change from mid-2006, when this model gave a screaming buy. (I use a more sophisticated version of this for my own trading that includes other assets and a cyclical adjustment. I'm not posting that.) This indicates we should see a 10% or so gain in stocks this year. Not great, but not worth betting against either.