Bullish newsA widely reported indicator of stock market valuation reached a 58-year high recently. This indicator is the ratio of the earnings yield on stocks to the yield on Treasury bonds, and it is a good proxy for a of couple fundamentals that go into stock valuation, namely:
- Prices relative to underlying earnings. Stock prices have gone up by a tremendous amount over the past several decades, but that doesn't mean that stocks keep getting more and more expensive. What matters from a fundamental investing standpoint is how much prices go up relative to the underlying earnings. So, everything else being equal, a stock selling at $20 a share with $2 a share in earnings should look the same to an investor as a stock selling at $40 a share with $4 a share in earnings. Both stocks would have a price-to-earnings (P/E) ratio of 10, and the earnings yield is simply the inverse of that P/E ratio.
- The discounting value of interest rates. By comparing the earnings yield on stocks to bond yields, investors are acknowledging that interest rates discount the value of future earnings. The higher interest rates are, the less valuable future earnings appear. However, with interest rates as low as they are now, future earnings are not discounted by much, which makes stocks appear more valuable.