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High level determination of relative valuation of stocks vs. bonds

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  • High level determination of relative valuation of stocks vs. bonds

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ID:	16626764Now that we have covered the importance of asset allocation, it is time to get a handle on how expensive (or not) the stock market is. This can be done on an absolute level or as compared to the bond market. The bond I prefer for this comparison is the 10- year US Treasury. Of course, this benchmark should only be used for the US stock market. Other markets should probably use the respective countries' 10-yr bonds.

    This article will address the relative valuation of the US market wrt the 10-yr Treasury. The market's price to earnings ratio (P/E) can be computed by dividing the market index by the earnings, and is readily available. The inverse of this is the earnings yield, represented as a %. The dividend yield of the market as a whole is similarly computed. For example, the earnings yield of the S&P500 is about 6.6%. The dividend yield is 2%.

    And what is the 10 yr bond yield? A rather lean & mean 2%! Exactly equal to the market dividend yield. Since the market price is just the net present value (NPV) of all future dividends, it is appropriate to compare this with the 10 yr bond yield.

    The bond yield does not compound with time. While the dividend yield does. So while the stock market has gone up 125% from the March 2009 low, it still appears to be more attractive than the ten year bond. Well, not very surprising. Because the bond market has been on a 10 year bull run.

    While I do not have the 10 yr yield in Oct 2007, I suspect it was around 5%. And the stovk market dividend yield? Around 1.5. Clearly 5% is much greater than 1.5%. The bond market was more attractively priced in October 2007. The rest is history.

    It is that simple. Of course, those who read Investment 001 would have already set their asset allocation. And would be balancing the allocation maybe 3 times a year. For them, this article is nothing more than of academic interest.

    About the writer: he is never known to lose his Cool. And never participates in heated arguments.

    • Southie
      #1
      Southie commented
      Editing a comment
      Re: Article: High level determination of relative valuation of stocks vs. bonds

      The last. line of 3rd para from bottom should read " bond market has been on a 30 year bull run."

    • CEO1
      #2
      CEO1 commented
      Editing a comment
      How is it that Germany can offer bonds at negative interest rates? Shear cockiness or frugality at its best? Either way high net individuals from the periphery countries are running to take them up.

    • Southie
      #3
      Southie commented
      Editing a comment
      Bond rates ( I think) are determined by the market. During financial crisis people flocked to German govt bonds ( and us treasury) thus driving their price higher and yield low. The 10 yr yld on German bonds is abt 1.6%. Us is 2%.

      There may be a bubble in German bonds also. Not sure this has anything to do with frugality or cockiness. Lots of demand so price high. I expect ylds to go higher I. 12 months.
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