No, I haven’t lost it.
I feel like the rest of the world has, honestly.
You’d assume that after a 10-year bull market, stocks would be expensive. But as I explained yesterday, that’s not the case.
Stocks are cheaper than just about anyone realizes. And it’s all thanks to incredibly low interest rates.
Today, I’ll explain exactly how to see this… and exactly what it means for your money.
In short, this isn’t the time to give up and sell. Stocks are cheap… and you want to own them now.
Before we get to the details, we need to take another look at the chart I shared yesterday…
Again, it shows stock market affordability… a measure of stock prices, valuations, and interest rates.
Historically, this measure has done a great job of pegging the major tops and bottoms in the market. Take a look…
Surprisingly, this measure also says stocks are dirt-cheap today – even after a 10-year bull market.
I’m not some kook making up numbers to prove my point, though. I’m simply comparing stock valuations with interest rates to come up with a simple “fair value” for the market.
The math here is pretty simple…
In order to compare apples to apples – and look at stock yields versus Treasury yields – I invert the price-to-earnings (P/E) ratio. As I said yesterday, the P/E ratio is the most common benchmark for stock valuations.
Flipping the ratio still shows us whether stocks are expensive or cheap. It’s just the E/P ratio instead of the P/E ratio. In finance, we call it the “earnings yield.” So, if the P/E ratio is 20, then the earnings yield is 5% (1 divided by 20).
Now that you know all the “ingredients,” here’s the secret to how my stock market affordability indicator works…
Whenever interest rates are high relative to the earnings yield, stocks are expensive. And whenever the earnings yield is high relative to interest rates, stocks are cheap.
This is crucial to understand if you’re worried about how to invest today.
Just take a look at the next chart. You can see these two yields broken out separately. And if you look closely, you’ll notice something interesting…
Over history, the relationship between the earnings yield and interest rates has held up pretty well. When it gets out of whack, something big happens to push the relationship back into place.
In late 1999 for example, bonds paid nearly 7% interest. But the earnings yield on stocks was around 3.5%. So stocks were a terrible deal in late 1999 relative to bonds.
We all know what happened next… Stock prices crashed, and the earnings yield soared (remember, yields and prices move in opposite directions). Meanwhile, investors fled to safety… pushing bond prices up and yields down.
By 2004, both lines on this chart were moving together again. And that brings us to today…
This month, astonishingly, 10-year Treasury yields fell to a crazy low level – below 1.5%. Meanwhile, at a P/E ratio of 19, the earnings yield on stocks is above 5%.
So this time, bonds are a terrible deal compared with stocks.
To get this relationship back on track, either stocks need to absolutely soar, or interest rates need to skyrocket… or both.
Now, don’t get me wrong. While this relationship has highlighted some key market moves, it doesn’t have to be perfectly one-to-one today. It doesn’t guarantee stocks will continue higher.
But it does tell us something about the relative value of different investments. And that’s important when deciding what to do with your money now. It’s the only way to determine what’s cheap or expensive… and what’s a good deal or a bad deal.
Our takeaway from all this is simple, but powerful. Right now, stocks are an incredible deal relative to bonds. Plus, we can see that we’re nowhere near a bubble today.
I urge you to take advantage of this. Stocks are cheap today… cheaper than anyone realizes. Now isn’t the time to sell. It’s the time to buy.
Good investing,
Steve
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Source: Daily Wealth