Relative Valuations Favor Stocks Over Bonds

One of the models that I continue to update and track over the years is the relative valuation model. Some people know this model as the IBES model, or the "Greenspan model," since its popularity blossomed after investors learned that former Fed Chairman Alan Greenspan used to follow it.

I won't go into too many details about the model. Truth be told, it's pretty straightforward. The model basically looks at the relative valuations between stocks and bonds. One way to think about it would be to compare the earnings yield on the stock market vs. the yield on Treasury bonds. When one asset class moves to an extreme vs. the other, the model suggests that you adjust your asset allocation in favor of the undervalued asset class.

Recently I saw that a well-regarded strategist called these models useless, saying that because of the difficulty in estimating forward earnings (one of the inputs to the model), these models were of no value to investors. Funny, I recall folks back in 1999 saying that these models were useless then also.

Back in 1999, the Greenspan model showed that equities were more than 60% overvalued relative to bonds, but few investors heeded the signal (or warning). Today, we have the opposite situation: The model is saying that stocks are more than 60% undervalued relative to bonds.

Click here for larger image.

Source: Beverly Investment Advisors

Now, let's remember that these are relative models, not absolute. By that I mean that the model isn't simply saying that stocks are 60% undervalued, they are also saying that right now, bonds may be significantly overvalued. And this is an important point. Although the term "bubble" has been thrown around a lot in recent years, it might not be such a stretch to apply it to what's happening right now in short-term Treasuries.

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At time of publication, Kahn had no positions in the stocks mentioned.

Jordan Kahn, CFA, is a portfolio manager with Bevery Investment Advisors, a Beverly Hills, Calif., money manager. Under no circumstances does the information in this commentary represent a recommendation to buy or sell stocks. Kahn appreciates your feedback; click here to send him an email.