One of the topics that has dominated the post-Brexit equity market environment has been market valuation, specifically the market’s valuation in relation to bond yields.
A broad selection of analysts across Wall Street have weighed in on this issue, and all have reached very different conclusions — hardly surprising considering the fact that they’ve all used different data samples.
For example, last week analysts at Bank of America declared that stocks look cheap compared to bonds when valued according to the Fed model of equity valuation. The Fed Model is based on the comparison of the earnings yield on stocks with bond yields. Bulls argue that the spread between bond yields and the earnings yield will normalise as equity valuations re-rate higher – a simple mean reversion trade.
According to Bank of America’s analysis, the current S&P 500 earnings yield of 6% exceeds the 10-year Treasury yield of 1.6% (the lowest in history – it should be noted) by over four percentage points. According to the Fed Model, the S&P 500 forward earnings yield could drop as low as the yield on the 10-year Treasury, which implies significant upside from current levels.
Are equities cheap or expensive?
A week before Bank of America’s analysis was published, Dominic Konstam and team over at Deutsche Bank sent a research note to clients highlighting that over the past 30 years the equity risk premium has averaged 2%. Today the premium is still some 2% higher than its historical average, implying that the S&P 500 could rally by another 200 points from current levels to make up the difference. In the same week, to add to the confusion, analysts at BCA Research published a note showing that between 1871 and 2016, the equity risk premium on US stocks is 5.5%, compared to just 4.7% today.
And now Goldman Sachs has decided to add to the confusion. In the bank’s US Weekly Kickstart research note analysts write:
“A convergence of the current 415 bp yield gap to its long-term average of 250 bp would require further expansion of the S&P 500 forward P/E multiple to 25x or 10-year US Treasury yields to rise to 3%. However, at 18x, equity valuations are already stretched and have never surpassed 20x outside of the Tech Bubble. Although bonds have provided a higher YTD risk-adjusted return than stocks, consensus implies a 12 month index level of 2330 and a prospective Sharpe Ratio of 0.6 for equities vs. 0.1 for bonds. Our 12-month target of 2150 implies a total return of 1.5% and a risk-adjusted return similar to what futures implies for bonds, consistent with history.”
The ‘yield gap’ Goldman is referring to in the above quote is the difference between the S&P 500 earnings yield versus the US Treasury yield. Goldman’s working:
(Click to enlarge)