How do you measure stock market valuation?
If you look at conventional measures – like price-to-earnings (P/E) ratios – then U.S. stock markets appear to be pricey. The Wall Street Journal reported trailing 12-month P/E ratios are high when compared to 10-year averages.
High P/E ratios haven’t dampened investors’ interest in U.S. stocks, and share prices have been moving higher. The Dow Jones Industrial Average (Dow), Standard & Poor’s 500 Index, and NASDAQ all reached new highs last Thursday – the first time that has happened since 1999.
Barron’s suggested investors’ enthusiasm for stocks is rooted in the search for yield. “With the Treasury’s 10-year note yielding 1.5 percent – near lows not seen before in modern history – there’s no alternative to stocks for investors who want returns.” Of course, that’s a bit of hyperbole since there are many types of investments that offer income to investors. Let’s focus on stocks and bonds, though.
The relationship between stock yields and bond yields may have some investors measuring market valuations in different ways. Investopedia reported, during the late 1990s, Wall Street professionals came up with a new method for gauging stock market valuation. It was called The Fed Model and it determined full valuation by comparing stock yields to bond yields. (Please note: ‘The Fed Model’ wasn’t created by the Federal Reserve System, and the Federal Reserve System does not endorse it.)
The Wall Street Journal offered this analysis:
“…the so-called Fed model, which says that stocks’ earnings yields – that is, expected annual earnings divided by the share price – should equal the yield on the 10-year Treasury note. With the 10-year now yielding 1.52 percent, the Dow would be fairly valued at 66 times earnings rather than the current, measly 18. Dow 68,000 anyone?”
It’s an enthusiastic estimate. While some analysts are speculating the Dow could surpass 20,000 during the next 12 months, according to CNBC, others are suggesting investors proceed with caution.