Pandemic Versus The Fed: Are Stocks Overvalued Or Not?

(Global X) At the height of the COVID-19-induced panic in March, few would have thought the market would recoup all its losses within five months. But that’s what happened—and then some. The S&P 500 Index hit a new all-time high on August 18 and has continued to trend higher until September 3rd when valuations and the growth focused nature of this rally came back into focus.  While it is normal for the market to recover before the economy, the market’s more than 50% increase since its trough in March raises questions about valuations. Has the market got ahead of its fundamentals?

These questions are particularly relevant with the economic recovery still so uncertain. However, with interest rates close to 0%, future earnings are just about as good as current earnings—provided future earnings have some degree of certainty. This has boosted demand for investments that were less impacted by the pandemic – pushing the valuations on growth relative to value to its highest levels in almost 20 years. While cheap relative to bonds, equities appear expensive relative to historic valuation levels. However, the market’s changing composition, in part due to COVID-19, is another important consideration in our conclusion that, while high, current valuation levels on aggregate are not yet overly concerning.

 

Divergent Yields Favor Equities

Prior to 2008, the correlation between the earnings yield on the S&P 500 Index and the yield on 10-year Treasuries was 72.2%. Since then, the sharp decline in interest rates following the Global Financial Crisis has almost completely removed this relationship. If this relationship still held, equity market valuations would be far higher than they are today.

Typically, Wall Street compares the earnings yield on the stock market with the long-term Treasury yield to get a broad sense of if equities are cheap or expensive relative to Treasuries. Chart 1 tracks the premium or discount of the earnings yield relative to the yield on the 10-year Treasury since 1960. Generally, the market would expect the earnings yield to be higher than that of Treasuries because it also needs to reflect an equity risk premium. Conversely, the market would expect earnings to grow over time, so this higher growth rate has the potential to partially or even fully offset the equity risk premium.

Given the exceptionally low yields on Treasuries today, the stock market looks attractive relative to the bond market. (Read more)

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