Wednesday, June 02, 2010

Stocks Undervalued and/or Bonds Overvalued?

Below is research on the difference between stock and bond yields and subsequent 12-month forward stock market returns. The data was pulled together by Argus Research.
"The chart below depicts (on the right axis) the gap between the yields on the benchmark 10-year Treasury note and the S&P 500. Plotted against this series is the performance gap between the return on the S&P 500 and the return on the 10-year Treasury over the subsequent 12-month period.

Generally, a yield gap of 400 basis points or less has proven bullish for stocks. More notable, however, is that extreme levels have been very predictive of the market’s future direction. For example, the yield gap peaked in the fourth quarter of 1999 at 535 basis points, accurately foreshadowing that stocks were quite overvalued relative to bonds. Alternatively, in March of 2003 the gap had shrunk to just 150 basis points as bond yields had plunged and stock prices had sunk to bear market lows (thus pushing up dividend yields). The current readings are even below the March 2003 levels, suggesting that stocks are quite undervalued."

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