Despite the recent S&P 500 rally, stocks are still cheap relative to bonds, that’s the key takeaway from a research note out today from Bank of America Merrill Lynch, which looks at the Fed Model of equity valuation.

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The Fed Model is based on the comparison of the earnings yield on stocks with bond yields. It’s a simple strategy the many investors tend to overlook in favour of more complex valuation methods.

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. However, the spread can also mean-revert if earnings start to fall, or interest rates spike.

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Unfortunately, these two drawbacks call the reliability of the strategy into question and lead Bank of America to conclude that the Fed Model may not be as clear-cut a buy signal for equities compared to other valuation models. The bank’s analysts write, “our analysis suggests that the various forms of the Fed model have far less predictive power than simply using a PE ratio.”

Stocks are cheap…compared to bonds

There is clear evidence that the Fed Model has been a useful buy indicator for equities in the past. Between 1982 and 1997, the correlation between the S&P 500 forward earnings yield compared to the 10-year Treasury yield was 94%. But, soon after the Federal Reserve published a report highlighting this relationship, the move appears to have stopped working. Between August 1997 and June 2016, the correlation between the two metrics has dropped to 69%.

Stocks are cheap...compared to bonds
Stocks are cheap…compared to bonds

Still, a comparison between the S&P 500 earnings yield and bond yields implies that there could be further upside ahead for the end. 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, (or at least according to the Fed Model up to July 1997) 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. That said, based on the fact that the Fed Model hasn’t really shown much dependability since 1997, it is unlikely such scenario unfold.

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Another way to view this is from an equity risk premium perspective. The equity risk premium is the excess yield earned by investing in equities over the risk-free rate as compensation for taking on equity-specific risk. The equity risk premium has averaged 1% since 1982, and the current spread (based on the S&P 500 earnings yield of 6% and the 10-year Treasury yield of 1.6%) is 4.4%, 3.3% higher than the average since 1982.

Analysts at Bank of America aren’t the only ones to have spotted this trend. Last week Deutsche Bank’s Dominic Konstam and team wrote in a research note that over the past 30 years the equity risk premium between the S&P 500 and 10-year Treasury is around 2% and today, the premium is still some 2% higher than this historical average. Deutsche Bank’s analysts go on to estimate that the S&P 500 could rise another 200 points from current levels to make up this difference.

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Despite the differing figures, the conclusion is the same: stocks look cheap compared to bonds, no matter which interest rate-based model you use, (including DCF) they all come to the same conclusion.