Posted by David Matzko
Tuesday, May 3, 2022
We know stocks have gotten cheaper on traditional valuation metrics as a result of the latest market correction. The most commonly used valuation tool, the price-to-earnings ratio (P/E), has fallen from over 21 to under 18 this year based on the consensus estimate of S&P 500 earnings per share for the next 12 months (source: FactSet). For those fans of using last 12 months, or trailing earnings, the S&P 500 P/E has fallen from over 24 to under 20 year to date. This makes sense given earnings, and earnings estimates, have risen as stock prices have fallen. That valuation is still a bit elevated but seems fair.
But what about stock market valuations relative to bonds?
We know from studying market history that higher interest rates tend to correspond to lower stock valuations, and vice versa. (We wrote about that very topic here.) But have bonds gotten cheap enough, i.e., have yields moved high enough, for bond valuations to be as attractive as stocks?
“Stock valuations are still surprisingly attractive relative to bond valuations despite sharply higher interest rates,” noted LPL Equity Strategist Jeffrey Buchbinder. “Granted, relative stock valuations are nowhere near the levels reached early in the pandemic, but we still see them as supportive.”
We can measure the relationship between stock and bond valuations by comparing earnings yields to bond yields, giving us the so-called equity risk premium (ERP). The ERP compares the earnings yield on the S&P 500 (the inverse of the P/E) to the 10-year US Treasury yield. That number as of May 2 was 2.1%, above the long-term average of 0.8%, as shown in the LPL Financial Chart of the Day. That means stocks are more attractively valued on this metric today than they have been on average historically.
Stocks still aren’t cheap and higher interest rates have made it tougher for stocks to hold their valuations. But despite the sharp move higher in interest rates—a double from 1.5% to 3% since January 1—we would still argue that stocks offer relative value compared with bonds based on the equity risk premium. In fact, even a 10-year Treasury yield up at 4% (not our expectation) would leave the ERP above average at 1.1%, creating some valuation cushion for stocks.
The LPL Research Strategic and Tactical Asset Allocation Committee maintains its preference for stocks over bonds, and continues to recommend a modest overweight allocation to equities, as appropriate.
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