Back to Parity

Global equities capped off another banner year in 2006, with the MSCI World Index returning 20% in dollar terms. Since the bull market began in March 2003, the index is up over 120%. After so much strength, you may be tempted to think the bull market is nearing its end. In reality, equities remain undervalued when compared to other asset classes, such as cash and bonds.

As we've written many times before, the simplest and best way to compare stocks to bonds and cash is to flip the P/E ratio to get an earnings yield. (see our previous commentary, "Flip It to See Stocks' Value"). Doing so gives you a novel apples-to-apples method for comparing stocks to other investments.

And right now, every major country's equity earnings yield is higher than its respective 10-year bond yield. In fact, the spread between earnings yields and bold yields is right around the same levels as the beginning of the bull market. Most investors lose sight of this, but earnings have been growing just as fast as equity prices over the past several years.

To give you an example just how undervalued equities are right now, take a look at the table below. We use US figures here, but this analysis can be done for any other country (in fact, it actually looks better with any other country!). The table shows the yearend 2006 value of the S&P 500, and its expected earnings per share (EPS) for yearend 2007. Again, putting these two figures together gives you a current earnings yield of 6.7%, a full two percentage point spread over US Treasury yields. But really crazy are the figures below that show what it would take to for stock and bonds to get back to parity (or, equal yields). Stocks could return over 40%!

As we've said in prior commentaries (see "Ho Hum - Another Stellar Earnings Season" and "Much to Be Thankful For"), we don't see bond yields rising or earnings falling significantly any time in the near future, which leaves further equity appreciation as the most likely outcome. Add in favorable equity supply trends and strong global economic growth, and this bull has room to run.