Stocks' Relative Valuation Conundrum

Corporate Bond Indices

A third alternative is a twist on the second, and that is comparing the spread of a broad class of corporate bonds to a broad stock index. Let's compare the option-adjusted spread for investment-grade bonds, plotted inversely, to the large-capitalization Russell 1000 index. The dates of the three most recent FOMC meetings are marked with green, magenta and pale blue lines here and subsequently.

Large-Capitalization Stocks Still High Relative to Credit Spreads

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Source: Bloomberg, Howard Simons

So long as investment-grade bonds had a stable spread to Treasuries, the Russell 1000 rose. Once the spreads widened in late July, stocks moved into their present trading range. If the Russell 1000 was beholden to corporate credit, it should have fallen severely by now.

As an aside, corporate credit spreads narrowed slightly after the September rate cut, but widened thereafter. The Federal Reserve has done nothing to restore order to this market.

The match between high-yield corporate bond spreads and the small-capitalization Russell 2000 index was even closer until late July. Once again, if stocks were beholden to corporate bonds, the Russell 2000 should have been in full retreat by now.

Small-Capitalization Stocks Still High Relative to Credit Spreads

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Source: Bloomberg, Howard Simons

Unless we are willing to believe that stocks have supplanted bonds as a less risky asset, we have to conclude that stock investors feel they are getting something in return for ignoring the bond market's screaming. That "something," I wrote last May and continue to believe, is a recognition foreign buyers and others willing to price stocks for control will continue to buy U.S. equities. Our trade and budget deficits and our wounded financial intermediaries demand the vast quantities of capital available at the sovereign wealth funds. This put America up for sale and it will be the foreign buyers, not the Federal Reserve, who will end our credit crunch by buying U.S. assets.

Back to the Fed Model

Let's reconstruct the Fed model at the 10-year horizon by using consensus top-down expected price-to-earnings ratios for the broad-based Russell 3000 index and the Russell 3000 growth and value indices. In each case, the more negative the relative valuation number, the more undervalued the stock index is relative to the 10-year Treasury.

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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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