NEW YORK (CNN/Money) - Sure, stocks are getting more expensive and yes, Treasurys are getting cheaper. But that doesn't mean the rally in stocks, or the slide in bonds, is going to end soon.
With Wednesday's rally to a new 14-month high, the S&P 500 now trades at a hefty 20.3 times the past year's operating earnings -- an even heftier 35 times if you choose to be cruel and insist on looking at earnings under generally accepted accounting principles.
Using analysts expected results over the next year you get a price-to-earnings multiple of 17.9. Historically that's not cheap at all, but for people who follow the "Fed stock valuation model," which says the stock market should throw off around the same earnings yield (that's the inverse of the P/E for the number crunchers out there) as the yield on the 10-year Treasury note, things don't look so bad.
According to the Fed model (it's called that because, for obscure reasons, some people think the Fed uses it), the S&P should carry a forward P/E of 21.7. That would put the index 21 percent higher than it is now.
Are there problems with the Fed model? You bet. First, it relies on analyst estimates, which are often silly. (In this case they expect 10 percent earnings growth, which may actually not be so far off the mark.)
Second, the environment where stocks are 21 percent higher than they are now is also an environment where the yield on the 10-year Treasury is higher than the current 4.6 percent.
Put another way, bond yields, price off of inflation expectations. And earnings and inflation should have a lot to do with each other -- over the long run they track each other quite well. If the analysts are right, bond yields should be higher, which means that stocks aren't quite so undervalued. If the bond yields are right, the analysts have overstepped it. Which means that stocks aren't quite so undervalued. Or so the argument goes.
Stepping back, it's important to remember what the Fed model is trying to get at. You buy a Treasury, you get a return that's guaranteed by the U.S. government. You buy a stock, you want to get that return plus compensation for the risk that you are taking. At some point, investors take a look at Treasury yields and decide that they make buying bonds more worthwhile than stocks.
That simply isn't a point we're at now. Expectations for a big stock market rally through the end of the year are building, making a 4.6 percent annual return seem piddling.
Maybe at some later date, with hindsight, investors will wish they'd bought the bonds. But (with the exception of those hedge fund managers now in Eliot Spitzer's sights) investing with the benefit of hindsight isn't something we get to do.
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