Long term bond yield of 6.3% needed to erase valuation disparity with equities

Last weekend, the Wall Street Journal carried an interesting article on the current valuation of the S&P 500.

http://blogs.wsj.com/marketbeat/2011/03/11/give-it-to-me-straight-are-stocks-cheap-or-not/?KEYWORDS=Shiller#

In it, Professor Robert Shiller argues that the index is overvalued based on its current P/E ratio using a 10 year moving average of earnings.

However, looking at the value relationship between equities and long term bonds, we reached a very different conclusion:  Equities are significantly undervalued compared to bonds despite the rise in equity prices over the last two years..  The extraordinary low long term rate today might  justify some or all of what Prof Shiller's observes, i.e. at a 3.46% yield, long term bonds have a p/e of close to 30x.

Using the Corequity valuation model, we can measure how much prices would have to change to be back in a more balanced value relationship.

First, we normalize the the Long Term yield, using the data that Prof. Shiller kindly makes available on the their website and referred to in the article.

The next step is to show the history of relative valuation (Payback) of long term bonds vs equities.

This shows that there had been a period of relative stability in this relationship in the late '80s and 90's which was followed by a rise in relative valuation of bonds as rates continue their secular decline.

Assuming that the earlier period is a reasonable standard of value,  we would expect bonds to be between 100 and 200 percent of the S&P 500 payback.  Using this range, the following chart shows the calculated prices compared to the High, Low and Closing prices for long term bonds.

To be fairly valued in this relationship, bonds would have to decline about 45% to yield 6.30%,  up substantially from the current 3.46%.  More likely, the correction would take place with stocks rising as bond  prices fall.

Robert L .Colby