"Is the S&P 500 cheap or expensive" - that is the question every trader has to answer every day.
It is also the question BofA's Savita Subramanian addresses today in a report which deconstructs the "Fed model", or the goalseeked analysis which justifies high stock multiples (and prices) as long as bond yields are low (contrary to virtually all other valuation models). This is what she says:
As equity markets make new highs, the bulls are grasping for new (or very old) ways to justify the rally. The latest to garner attention is the Fed model, which compares the earnings yield on stocks with bond yields. There have been many iterations of the Fed model over the years, but they all come to the same conclusion today: stocks are cheap relative to bonds. The bulls argue that the spread between bond yields and the earnings yield will normalize as equity valuations re-rate higher. But this is just one of the ways that the relationship can mean-revert - which it has failed to do over the last decade. The other two may not be as bullish – the spread can mean-revert if earnings were to collapse, or if interest rates were to spike. Thus, the Fed model may not be as clear cut a buy signal for equities. And critically, our analysis suggests that the various forms of the Fed model have far less predictive power than simply using a PE ratio.
But while we will dissect the Fed model rationalization at a later time, let's address the original question: are stocks over or under valued. The answer is nuanced.
With equity markets making new highs, the bears have egg on their face, at least for the time being. Margins have not collapsed, China has not imploded and credit markets are still open. But at the same time, the bulls are running out of ways to justify the rally. Valuations are no longer cheap, central banks appear to be running out of bullets and the hopes of a big rebound in growth just around the corner appears fleeting. In the near term, it appears that only thing to really hang your bullish hat on is weak investor sentiment and the idea that stocks are more attractive than the alternative (i.e. cash and bonds).
Vague enough yet? If not, then here is the full answer, or rather 20 answers, because BofA does the proper thing and instead of giving one blanket statement to the most fundamental question, it looks at the 20 most important valuation measures, and finds that the market is overvalued, in some cases dramatically, according to a majority of the most popular metrics.