Fortune — At Thursday’s confirmation hearing for Janet Yellen, the nominee to be the next Federal Reserve chairman was asked whether she thought there was a bubble in the stock market.
Yellen gave a pretty clear answer: No.
“Stock prices have risen pretty robustly,” Yellen said. “But I think that if you look at traditional valuation measures, you would not see stock prices in territory that suggests bubble-like conditions.”
Perhaps Yellen should have been even more bullish.
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There are a number of ways to judge whether stocks are overvalued or undervalued. But the one most associated with the Fed — it’s nicknamed the Fed model — is to compare the stock market’s earnings yield, which is earnings/price or the inverse of the popular price-to-earnings multiple, to the interest rate on 10-year Treasuries.
The stocks in the S&P 500 (SPX) are expected to earn a collective $119.19 a share over the next year, according to FactSet. Divide that by the S&P 500’s recent 1792, and you get an earnings yield, essentially how much the average stock is expected to return in income a year, of 6.8%.
The idea is that if you can get the same expected return from bonds, which are generally considered lower risk, buying stocks makes little sense. As bond yield approach stock yields, sell. On the flip side, when stocks yield more than bonds, buy.
The Fed has never officially blessed the model. But Greenspan referred to it regularly, and Yellen’s comments on Thursday suggest she looks at bond yields when valuing stocks as well.
The rate on 10-year government bonds is 2.7%. That means stocks are not only cheap, they’re a screaming bargain.
Critics would contend that the Fed model is meaningless right now. The Fed has been artificially driving down interest rates. That’s what’s making stocks look cheap.
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But even before QE, some strategists thought the Fed model was flawed. Stocks and U.S. government bonds have different levels of risk. So back in the 1980s a number of prominent strategists contended that what you really needed to do was compare the earnings yield of the market to the expected interest rate on AAA-rated corporate bonds. Best guess for that is 4.9%, according to Randell Moore at Blue Chip Economic Indicators, which polls economists. So by that measure stocks are still cheap, but not by nearly as much.
Back in the ’80s, though, lots of U.S. companies were rated AAA. Few are today. The most common rating for U.S. corporate bonds is BBB+, one notch above junk. The expected yield on those bonds is 5.9%. Use that yield, and we’re not that far away from where the Fed model starts flashing sell.
We might get there pretty soon. When the Fed slows its bond buying, which most people expect will happen by the middle of next year, interest rates on all bonds are likely to go up, not just Treasuries. And corporate bond yields don’t have to move up much before stocks go from looking cheap, to rather expensive. Bubble territory is not as far away as it looks.