Why the S&P is (a bit) cheap

“If a picture is worth a thousand words, data is worth a thousand pictures.” — No one famous (ie me)

Since the crisis low of 677 in March 2009, the S&P 500 has risen exactly 300% to close yesterday at 2,028. How long will the run continue? For the second half of 2014, we’ve heard a lot about equity markets being overvalued.

But what do the numbers say? Where are we in terms of S&P’s valuation compared to (1) other countries’ indices, (2) historical valuations and (3) bond valuations?

Cheaper versus the World

We look at a few major, mainly developed market indices around the world in the table below. Of the 17 indices, the S&P ranks 6th cheapest (meanwhile, the tech heavy NASDAQ stands out as extremely expensive).

Historical P/E: Middle of the road

In relation to the world, the S&P looks reasonably priced, but equity markets, especially in developed markets, tend to be quite correlated. So how do we stand in relation to history. Using data from 1962, the average P/E ratio was 16.7, while it is a touch higher at 18.0 today. That puts it above (more expensive than) 64% of the observations in our period.

We have been over 30 during the dotcom boom. Most of the lowest readings occurred in the late 1970s and early 1980s.

The BEER: Dead sober

Traditionally, investors choose between stocks and bonds to make up their portfolio. So let’s look at valuations of stocks compared to bonds. The BEER is the Bond Equity Earnings Yield Ratio, but we’ll work with the difference instead.

The graph below shows that plummeting bond yields (orange) have pushed the yield differential (grey) to well above its long term average. Note that the equity yield is simply the inverse of P/E ratio, where a higher yield signifies a cheaper valuation.

The difference between equity yield and bond yield, at 3.77%, is higher than 93% of historical observations.

However, the differential is being driven much more by low interest rates than by high earnings yields. With rates historically extremely low, and rising rates likely to suck out liquidity from the stock market as the Fed deleverages, this spread in favor of owning equities may be deceiving.

Still a bit cheap

Despite the massive run up in price in the last six years, the S&P does not appear to be overvalued — it looks slightly cheap globally, slightly expensive compared to the historical price to earnings average, and very cheap when compared to bonds. This is NOT a prediction of what will happen this year; just an observation of where we stand right now.

Data sources: Data from Bloomberg, EODData, and CRSP.