This Week In Finance

"Are Stocks in the Stratosphere? Part 2"

Last week we noted a recent Wall Street Journal story in which it was suggested that some of the traditional indicators of stock market valuation were at or near record levels. Interestingly enough, the latest issue of Smart Money also contains an article dealing with market valuation. The article, written by Roger Lowenstein (author of Buffett: The Making of an American Capitalist) is entitled "Is the Price Right" and leads with the promise: "So You Want to Know if the Stock Market is Overvalued. Here's the Answer." And, by sheer coincidence (?), the same topic is covered in articles in the March 16 issue of Barron's and in the March 17th edition of the Money Daily online newsletter .

Mr. Lowenstein concludes that "for a good while, the market won't sustain a further rise." This conclusion is based on an examination of the relative values of the forward earnings yield (anticipated EPS for firms in the S&P 500 divided by the current level of the index) and the yield on 30-year Treasurys. A graphic suggests that the two data series have run roughly parallel since January, 1985 and, more importantly, that whenever the bond yield exceeds the earnings yield, the former must fall or the latter must rise. Or, in the words of Mr. Lowenstein: "Either bond yields must . . . fall-in which case you are better off owning bonds-or earnings estimates must rise, a tough trick in the face of Asia's collapse and a slowing U.S. economy. That leaves a third possibility-that for a good while, the market won't sustain a further rise."

Now, without putting on a prognosticator's hat, you might find it interesting to raise this issue in class. Try to get student response to the following questions:

(1) What is the relationship (if any) between the earnings yield and the yield on 30-year Treasurys?
Answer: According to the article, investors compare the returns on risky assets (stocks) and lower-risk assets (Treasurys) and should always expect higher yields on the former to compensate them for the higher risk.

(2) Under what conditions would the above condition hold? Could it ever be "out-of-line" for an extended period? (Not according to the author of the article.)

(3) What was this (and other) market indicators suggesting in 1987 before the crash? In 1991 during the Bush recession? How about 3 years ago? Two years ago? A year ago?

The Barron's article gives some interesting background on the latter question. It is noted that the indicator is said to be a favorite of Alan Greenspan (so much so, that the subtitle of the article is " 'Greenspan model' indicates stocks today are overvalued by about 18%".)

And, the article points out that "the point of most extreme overvaluation came just before the crash in 1987, when stocks were 32% overvalued." It goes on to suggest that the indicator correctly indicated market undervaluation from 1993 through 1995, but that the market was "fairly valued" about the time that Mr. Greenspan commented publicly that investors were displaying "irrational exuberance" in bidding up share prices.

This topic is particularly appropriate in the discussion of the chapter on capital market history, topics such as risk and return, and market efficiency, as well as in a discussion of the use of (financial) ratios as "indicators" at the market (as well as the firm) level. Use this opportunity to bring the real world into the classroom! Good luck!

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