Robert J. Swartout, The Daily Record Newswire
I can remember back when the then-Fed chairman, Alan Greenspan, used the phrase “irrational exuberance” to describe an overheating speculative bubble in the U.S. stock market.
The financial press have been busy the last few weeks with a countdown to Dow 15,000 and the all-time high in “the market.” Over this last weekend I was at a dinner party with friends and was asked the question, “Do you think we are in another speculative bubble in the market”?
I responded that I think we are clearly in a speculative bubble and then realized we were talking about two different markets. My friend meant the stock market and I meant the fixed income market.
If we analyze the stock market and the bond market we might be able to determine which asset class is relatively cheap and which asset class is relatively expensive. In July 1997, Greenspan was chairman of the Federal Reserve and was required by law to present the Fed’s outlook on a variety of economic issues. At this meeting, Greenspan’s report included a graph that has come to be called the “Fed model” and it is a theory of comparing the stock market’s earnings yield to the yield on the 10-year U.S. Treasury bond.
Most stock market followers are familiar with a price to earnings ratio as a measure of relative value for stocks and it is self-defined as the price of the stock, “P”, divided by the earnings per share for the stock, “E”. The earnings yield takes the forward 12-month earnings estimate, E, and divides by the price, P.
In broad terms, an analyst might look at the history of the market’s earnings yield and compare that with the yield on the U.S. 10-year Treasury bond to determine which asset class might be more or less expensive. Clearly, there are many other factors an analyst should consider when conducting a review of asset allocation decisions for an investment portfolio, but this is a good “back of the envelope” first look at where we are today as compared with other peaks and troughs in the equity and fixed income markets.
Fed model
If you recall back to the late 1990s and early 2000s, we were in the height of the dot.com bubble or tech bubble and the stock market, led by the NASDAQ, was in a speculative bubble. The earnings yield, E/P, has roughly doubled over that time frame from 3 percent to 6 percent. The S&P 500 (SPX) price is up about 8 percent over this time frame so the vast majority of the E/P move has been a growth of earnings for the S&P 500.
In fact the March 2000 earnings for the SPX was $67.46 and the March 2013 earnings for the SPX was $85.39. Earnings are up almost 27 percent while prices for stocks are only up around 8.5 percent for the same time period. The yield on the 10 year Treasury has dropped from 6.02 percent to 1.85 percent from the end of March 2000 to the end of March 2013.
The Equity Risk Premium (ERP) is calculated by subtracting the 10-year yield from the earnings yield and, in theory, the equity asset class should be more attractive if the ERP is positive and less attractive if the
ERP is negative.
In the late 1990s, the ERP was at a negative 3 percent, suggesting that stocks were not as attractive as bonds. Since the peak in early 2000, the 10-year Treasury yield has declined from above 6 percent to around 2 percent today, resulting in a significant bull market in Treasury prices.
Remember that bond prices move in the opposite direction than rates. The ERP was 4 percent as of the end of January this year and the ERP has been on a steady upward slope during this past 15-year bull market in bonds and neutral market for stocks. Stocks have steadily become more attractive than bonds over the past 15 years and continue to be more attractive today.
So to answer my friend: Yes, the bond market would appear to be in a speculative bubble and when the Fed announces the end of their quantitative easing and a tightening of monetary policy, the only question will be whether the selloff in fixed income will be orderly or come in big and potentially painful chunks.
With regard to equities, the NASDAQ all time high was above 5,000 and we are currently at 3,491. The S&P 500 was at 1,498.5 in March 2000 and this May 30 it closed at 1,654.41. The SPX was up 10.4 percent over the past 13 years, or up 0.8 percent per year over the past 13 years. Clearly, the bubble is in bonds and the opportunity is in stocks.
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Robert J. Swartout is a vice president at Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; (585) 586-4680.
