Many notable investors have been making the case in recent weeks that the equity market remains overvalued despite being over 25% from its all-time highs. Robert Shiller’s work, Tobin’s Q, Comstock partners (see here) and John Hussman’s work (see here) all conclude that the market is overvalued, however, in their latest letter to shareholders Long Leaf Partners makes the case that equities are cheap – especially when compared to bonds:
“Equities offer a superior opportunity for investors today, particularly compared to fixed income. The earnings yield of the S&P 500 based on 2011 projected EPS is 9.4%. If adjusted for the approximately $100 of cash imbedded in the S&P, the operating earnings yield increases to 10.4%.The numbers are slightly more attractive overseas. Based on 2011 estimates, the EAFE Index earnings yield is 9.8%. If earnings grow organically from today’s depressed levels at only 5% per year (a rate that does not require the reinvestment of earnings because of current excess capacity), and even if the P/E ratio remains below the long-term average, an investor’s five year average annual return will be in the mid-teens.
By contrast, corporate bonds with fixed, taxable coupons yield much less than the growing, after-tax coupon that companies produce. The following table compares corporate earnings yields to bond yields at bear market lows since 1932. When stocks have been at their lowest levels, earnings yields havebeenanaverage of 2.8% higher than Aa2 bond yields. At the beginning of July earnings yields are 4.3% above debt yields or almost twice stocks’ relative attractiveness to bonds at bear market lows. We have rarely witnessed this much disparity in the benefits of being an owner of a growing coupon versus being a lender to a fixed one.
In spite of the short-term market noise that the “D’s” are creating, over the long-run equities will reflect the value of the free cashflow streams that businesses produce. We are highly confident that (1) the competitive strength of our companies makes them more certain to deliver growing free cash flow coupons than the average business; (2) our companies have superior corporate captains; and (3) the stock prices of our holdings are much cheaper than the S&P 500, EAFE, and the DJIA. P/Vs are in the mid-50% range for all three Funds, providing a large margin of safety as well as tremendous upside performance opportunity which will be magnified as values grow.”
The tug-of-war continues. Corporate balance sheets are definitely strengthening. Companies continue to pay down debt and improve the position of their balance sheets, however, they will likely remain reluctant to reinvest their profits if they do not feel increasingly comfortable with the sustainability of this balance sheet improvement. For the long-term investors this component of the balance sheet recession is largely ignored. I have and continue to believe this is a traders market in which valuations matter little. Ultimately, the macro trends are so fierce that the tides will sink or lift all boats. But the arguments remain fairly convincing from all parties. One thing is certain – uncertainty rules this market environment….
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