Stocks are Cheap Even if Yields Spike?

This might seem like a shocking headline from BK, but it is inspired by Warren Buffett suggesting the US stock market is cheap when compared to 10 Year Treasury yields. To be clear -BK is not, and does not, make a determination of cheap v rich valuations – BK’s investment style is rooted in human behavior rather than valuation. BK is simply pointing out what a few investors may be using as a “reason” to buy stocks.

In the past, Buffett has championed a valuation metric based on Total Market Cap to GDP – and by this metric the US stock market is significantly overvalued. The website Gurufocus does a great job of tracking this metric – currently total market cap to GDP is 130% or significantly overvalued.

The only other time the market was more overvalued was in 2000, when the metric reached 150%. So why is Buffett saying the market is still cheap?

It all has to do with rates. Using the Fed Model, which compares S&P 500 Earnings Yield to the 10 year Treasury rate, one finds that there is a lot of room for stock to run. Forward S&P 500 earnings are $134, when we divide this by the current price of the S&P 500 (2376) we get an earnings yield of 5.6%. It is easy to see that earning 2.3% on a 10 Year note is less desirable than earning 5.6% on stocks. BK suspects this is why Buffett is still buying stocks.

Assuming the earnings yield remains stable, then one might say that stocks are cheap until the 10 year rate rises to 5.6% – at this point stocks would be fairly valued.

BK will leave you with a little food for thought…When was the last time the 10 Year Yield was above 5.6%? A: In 2000.