Stocks' Relative Valuation Conundrum

Those who still believe in Santa Claus might believe that financial markets occasionally pass out gifts as well. How else can we explain the eternal search by traders and investors for an alternative that is "cheaper" on a relative valuation basis for any given level of risk?

The answer, of course, is that while investors might pay lip service to efficient markets, they believe otherwise. I found in a former life of designing option-based commodity hedges that I could present two alternatives to clients, one of which was initiated at a debit and the other at a credit.

Even if I could demonstrate that the debit alternative was the most efficient, clients always took the credit, so much so that I just stopped wasting everybody's time and simply presented the most attractive credit.

So here is a little free advice for all of you aspiring trading strategists: When the first step of a trade involves cashing a check, you will have their full and complete attention.

Stock-Bond Equivalence

There are several ways to link stock and bond prices. One common way, referenced here last week, is to compare the earnings-to-price ratio of a stock or stock index adjusted for earnings growth against the yield of a Treasury note. This method compares risky stocks against risk-free Treasuries and ignores the distortions produced in the Treasury market by the periodic flights to quality.

I noted in September that these distortions are powerful enough to render the breakeven rate of inflation in the TIPS market suspect, and TIPS and conventional Treasuries both have the credit rating of the U.S. government. Should we really feel comfortable comparing stocks and Treasuries when one market often acts as a refuge from the other? To ask the question is to answer it.

A second way, noted in August 2005, involves comparing the insured yield on a given corporate bond -- that is, a bond plus a protective credit default swap -- against that company's stock price. The premise here is simple. If the risk of lending money to a corporation rises and bonds stand senior to stock in a corporation's capital structure, then an investor should not be interested in the stock. However, as noted in May 2005, this simple premise can break down when a stock becomes priced for controlling interest in a corporation as opposed to mere ownership.

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Howard L. Simons is president of Simons Research, a strategist for Bianco Research, a trading consultant and the author of The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.

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