Are U.S. Stocks Attractive Again?

Based on his “Fed model,” Ed Yardeni seems to think so:

(More related charts can be found in Ed Yardeni’s Valuation Chartbook)

The basic idea behind the “Fed model” is that over the long run, the earnings yield E/P (the inverse of the P/E ratio) of the broad stock market should be in line with the 10-year Treasury bond yield. When the stocks’ earnings yield exceeds the 10-year Treasury yield, the stock market is considered undervalued; conversely, if the stocks’ earnings yield is below the 10-year Treasury yield, the stock market is considered overvalued.

According to Yardeni’s computations, the U.S. stock market has not been this undervalued since 1979… The important thing to remember, however, is that this perceived undervaluation can be corrected in three ways:

  • Stock prices may rise, pushing the E/P down, or
  • Earnings may fall, again, pushing the E/P down, or
  • The Treasury bond yields may rise (possibly, along with inflation)

While the first two can be anyone’s guess, the third, in my opinion, is a matter of when, not if…

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