Wednesday, January 19, 2011

Is the stock market over-valued relative to bonds?

The P/E ratio of the previous post can also be expressed as a "yield" (E/P) so that it can be compared to ten year treasury bonds. Using this metric, stocks (in blue) look historically cheap.

Stock yields are historically lower than bond yields because stocks have a growth premium built in.  The growth premium should drive up the stock price, and drive down the yield.  Bonds have no such upside potential.

However, stocks also have a risk premium built in because they are typically riskier than bonds.  The risk premium should drive down the price, and raise the yield.  The relatively high stock yields in 2010 suggest that risk premium is outweighing the growth premium.

The difficulty of course, is that dividend yields are affected by inflation, but stock yields are not (because both denominator and numerator are affected).
Slide from Roger Brinner of the Parthenon Group.

1 comment:

  1. Hi Luke,,.... Bonds do not have upside potential, where as stocks have an imaginary growth premium attached to it.

    Good Book on Options