Another measure we like to look at is the relative attractive of stocks versus bonds.  The well-known ‘Fed Model’ compares the earnings yield on stocks (i.e. the yield that stocks would have if they paid out 100% of their earnings to shareholders) to the yield on the 10-year government bond.  The chart below shows the Fed Model since 1980.  For two decades the two measures moved almost completely in line with one another, both when interest rates were high (like in the early 1980s) or low (like in the 1990s).  They got out of line in the 1998-2001 period as earnings yields fell. This was the period of the technology bubble which was, in retrospect, a good time to lighten up on stocks relative to bonds.  So the model was working accurately during that period as well.  However, since that point, as can be seen below, the two lines have diverged with stock yields rising and bond yields falling.  This has continued to where we are now with the spread between the two yield lines at record levels of over 750 basis points (bond yield at 1.8% and earnings yield on stocks at 9.4%).

Stocks at Biggest Discount to Bonds on Record

There are basically only 3 ways to resolve this situation in the longer term.  Either one of the following has to occur to bring these two measures back in line.

  1. Interest rates have to rise sharply from current levels (something almost no one expects in the current environment)
  2. Corporate earnings have to basically collapse (we’re not talking about a slowdown in earnings growth or even a slight decline; we would have to see a 30-40% decline in earnings)
  3. Stocks are under-valued and have to rise substantially.

 

Alternatively, we could see a combination of all three of the above.  This is probably the most likely final scenario; earnings growth slows down or even goes negative for a brief period of time but the economy does not go into recession, interest rates start to firm up as economic growth resumes and the stock market rallies.  The world has not changed so much in the past few years that we should be throwing out models like this that have worked for decades.  The volatility of financial markets has certainly gone up over the past few years, more information is passed on in real time thanks to the advent of more communications technology and money flows have become more concentrated with the plethora of larger hedge funds that also tend to be much more active investors.  All of this has contributed to larger and more immediate moves in financial markets and under-mined the confidence of the average investor in the system.  But, in the end, the simple laws of supply and demand and relative valuations will always win out.  This means that rationality will return and valuations will move back to historical norms.  This has been the one constant over the long term in financial markets and we don’t believe that it is going to change.

For now, however, investors have a huge degree of wariness about the outlook for both the economy and the stock market.  Some of this opinion is reflected in the chart below, which is the Investors’ Intelligence Bull/Bear Ratio.  This measures the bullish versus bearish opinions of a large sample of market letters and strategy reports put out by various brokerage firms and independent analysts.  Their cumulative track record over time has been quite poor as high levels of bullishness in these letters has been associated with market tops while bearish periods have given rise to market bottoms.  The Bull/Bear Ratio (charted over the last 3 years below) has therefore started to become recognized as a very good ‘contrarian indicator’ (i.e. going in the opposite direction to the recommendations has resulted in better market timing).  When the ratio rose above 2.0 times in January and April of 2010 and again in April of this year, we have seen stock prices lower over the following month.  Alternatively, the ratio actually went negative (i.e. more bearish than bullish opinion) in early 2009 and then again in the summer of 2010 (both period coincided with lows in the stock market followed by subsequent sharp rallies).  Interestingly, the ratio has been falling since the April peak and went negative again in September.

Bearish Sentiment on Stocks Back to Market Bottom Levels

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