The Battle Royale: Stocks Vs. Bonds (Which Is Right?)

The S&P 500 is at valuations higher than those in 1929 and rival those of 1999. Despite a recession, the index is 25% above where it was trading before the pandemic. The equity stampede is undoubtedly bullish about corporate earnings prospects and, by default, economic growth.  

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As the stock bulls party, bond investors are glum about future economic prospects. Bond yields are below where they were before the pandemic started. Current yields warn of paltry economic growth and little inflation in the future.

Flipping Valuations

Traditional equity valuation analysis frequently involves the comparison of a fundamental metric to share price. The result is often interpreted as quantifying the richness or cheapness of the numerator in the ratio. In the case of the more popular metrics like P/E or P/BV, that is price. 

By assuming the price is fair, we can reverse traditional logic and calculate what the market implies for the denominator.

For example, assume the P/E ratio on XYZ stock jumps to 20 after lingering around 10 for decades. With this knowledge, we can make one of two assumptions.

  • The price of XYZ is twice as high as it should be
  • XYZ’s earnings are going to grow at twice the historical rate in the future.

The first bullet point assumes XYZ’s price must decline to bring its valuation to fair value. The second bullet point assumes XYZ’s earnings must increase to get its valuation to fair value.

The Peak Concept

Before diving in, it’s important to note we use peak earnings and peak GDP throughout this analysis. Peak means we use the highest level of earnings or GDP at each point in time. This method helps eliminate anomalies and better focus on more durable trends. For example, the current peak earnings per share of the S&P 500 is $139.47/share, the highwater mark from 2019. The current level is $94.14. The peak P/E is only 26.50, as compared to the actual P/E of 39. 

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