In 1997, the Federal Reserve offered a valuation measure for the stock market. The model compared the earnings yield for the S&P 500 to the yield on the 10-year U.S. Treasury note. The earnings yield is forward earnings divided by price, which is the reverse of the price / earnings ratio. According to the model, the market is overvalued when the earnings yield is below the Treasury note yield (negative differential), and undervalued when the earnings yield is above the Treasury note yield (positive differential).
In the 1988 – 2007 period, the highest negative differential (based on year-end figures) was 2.61% in 1999. The differential remained negative and the market dropped precipitously, bottoming in 2002 when the differential moved to a positive 2.40%. The subsequent trend was up. The differential reached a high of 2.64% in 2005, and has been positive since 2002.
Standard & Poor’s current estimate for S&P 500 2008 earnings per share is $89.44. Dividing $89.44 by the S&P 500 index of 1396.60 (at the time of this writing) gives an earnings yield of 6.40%. The 10-year Treasury note yield is 3.94%. The positive differential is 2.46%, which is the third highest behind 2005 and 2007’s 2.53%. Based on the Fed model, the market is undervalued.
We can get the S&P 500 earnings implied by the model by setting the earnings yield equal to the 10-year Treasury note yield and then multiplying the S&P 500 index by the 10-year Treasury note yield. Multiplying 1396.60 by 3.94% gives implied earnings of $55.03. This is $34.41 below the current Standard & Poor’s earnings estimate for this year, and is the highest negative differential from actual earnings in the 1988 – 2007 period. Unless Standard & Poor’s is way off the mark, the Fed model is suggesting that investors in the aggregate are far too negative about the outlook for corporate earnings.
