Permanent Value

Week in Review 9/4/13

Bruce Doole
September 4th, 2013

Valuing Equity Markets

When you look at the valuation of the equity market right now, you could get the impression that it’s somewhat uncomfortably high, given the fact that we still have very low bond yields in the U.S. But that’s okay, because I think that a 2%-plus bond yield in the U.S. actually overstates the amount of economic distress or deflationary risk present in the U.S. economy right now.

So, if that’s the case, why are bond yields at 2%? The simple explanation is that you’ve had over the past couple of years a very large price-insensitive buyer in the market gobbling up lots of Treasuries, and that’s the Federal Reserve. You can see the impact that the Fed has had on bond yields when you look at the real yield on a 10-year Treasury bond. That is simply the nominal yield minus CPI inflation. Right now, the real yield is barely above 0%, which seems somewhat inconsistent with an economy that, while not booming, is still growing roughly 2% to 2.5% and likely to accelerate as we go through the remainder of 2013.

In a more normal world, where the Fed wasn’t buying up lots of Treasury securities, the real yield on 10-year Treasury bonds would be about 2%. When you combine that with the current rate of inflation, which is 1.5% to 2%, you end up with a bond yield of roughly 3.5% to 4%. A 4% bond yield is actually consistent with P/E ratios of between 15 and 20 times. The average historical P/E ratio when we’ve had bond yields around this level has been 17.4 times. So that is how I come up with the P/E ratio assumption. For the dividend yield assumption, we just assume the current dividend on the market compounded over time, and that is 2.2%.

When you put all of these numbers together, you end up with a 7.6% potential annualized return on the S&P 500 index.

 

Source: American Funds from Capital Group