The ‘most overrated argument’ for equities; Are stocks attractive just because bonds are not?

Jan. 14, 2014, 6:00 a.m. EST

The ‘most overrated argument’ for equities

Commentary: Are stocks attractive just because bonds are not?

By Mark Hulbert, MarketWatch

CHAPEL HILL, N.C. (MarketWatch) — Should you buy stocks just because there are no attractive alternatives?

That’s the question we all face these days, with cash yielding next to nothing and bonds seemingly such a poor bet. And almost everyone gives a “yes” answer. Sure, the stock market may be overvalued, and bullish sentiment may be at dangerous extremes. But with everything else even less attractive, stocks still come out on top.

Yet, as Humphrey Neill, the father of contrary analysis, famously once said: “When everyone thinks alike, everyone is likely to be wrong.”

And the current situation turns out to be no exception.

Consider what Vincent Deluard, European Strategist for Ned Davis Research, found when analyzing the historical support for the relative-valuation argument. For every year since 1945, he calculated the difference between the S&P 500’s (SNC:SPX)  so-called “earnings yield” and the yield on the 10-year Treasury. (The S&P 500’s earnings yield, of course, is the inverse of the P/E ratio, so whenever the market’s P/E falls its earnings yield will rise. Currently, based on trailing 12-month earnings, the S&P 500’s earnings yield is 5.4%. That‘s 2.6 percentage points higher than the yield on the 10-year Treasury.)

If the relative-valuation argument were correct, then the stock market historically should have performed better whenever this spread was greater — and vice versa. In fact, though, Deluard found no consistent relationship — little more than “statistical noise,” he told me in an interview. And he found the same result when focusing on Europe.

He therefore calls the argument based on relative valuations “the most overrated argument in favor of equities.”

The accompanying chart summarizes Deluard’s findings. Notice that, even if you disagreed with Deluard and believed that the chart’s pattern is more significant than mere noise, you still wouldn’t have much to hang your hat on: The stock market historically has been a below-average performer whenever the difference between the earnings yield and the 10-Year yield was close to where it now stands.

Surprised? You really shouldn’t have been. The current relative-valuation argument is really nothing more than the Fed Model of old, and that model has long since been discredited.

The nail in the Fed Model’s coffin, from my point of view, came more than a decade ago in a study by Clifford S. Asness of AQR Capital Management. Entitled “Fight the Fed Model,” it appeared in the Fall 2003 issue of the Journal of Portfolio Management. ( Click here to read a copy of Asness’ study.)

Asness’ findings are best understood in terms of a statistic known as the “r-squared,” which reflects the degree to which fluctuations in one thing predicts or explains changes in another. The r-squared ranges between 0 and 1, with 1 indicating the highest degree of predictive power and 0 meaning that there is no detectable relationship.

The table reports the r-squareds that Asness derived from tests back to 1926. Notice that, regardless of whether you’re using the earnings yield to forecast the market’s one- or 10-year return, you’ll do a whole lot better by focusing just on it — rather than interpreting that yield in light of prevailinginterest rates. There are also powerful theoretical arguments for not throwing your money into the stock market just because the earnings yield is higher than the 10-year Treasury yield. As Deluard points out, there is no theoretical reason why a wide spread between the two yields must converge. Furthermore, even if they do converge, that convergence could also come about by stock prices falling rather than rising.

To be sure, the stock market isn’t necessarily doomed just because the bulls are relying on a flawed argument. But if you can’t come up with a better argument for why the stock market should go higher, then you should be looking for ways to cut back your equity holdings rather than increase them.