To those of you who weren’t aware that the market has dropped 6% in the last month, we salute you! More than likely, you are doing exactly what you’re supposed to be doing: not worrying. The Monarchians aren’t worrying either. It’s not that we don’t care about losing money, but we feel safer about our investments now. First of all, we expect our high-quality stocks to drop less than the market in any market correction, which is indeed happening now. Secondly, a drop in the value of our stocks means they have become cheaper.
To that point, we now ply you with the famous “Fed Model” chart, which compares the yield (interest rate) on 30-year government bonds to the “earnings yield” of the S&P 500. Earnings yield is simply E/P, Earnings divided by Price, or the inverse of P/E. So, a 10 P/E is a 10% earnings yield. A 20 P/E is a 5% earnings yield. A lower P/E means a higher earnings yield, which means there is more value for investors.
The most notable feature of the current market correction is that bond yields have plummeted, as investors have fled stocks to the safety of safe bonds. This is normal when the market is concerned that a crisis is afoot. But in the long-term, bond yields and stocks’ earnings yields should be correlated. There are many reasons for this, but the main reason is that bonds and stocks are competitive investments. If bonds get expensive (lower bond yields), stocks should also get expensive (lower earnings yields). As the chart below shows, stocks have been cheap relative to bonds since mid-2004—the earnings yield line is above the bond yield line. Since 1982, there has been only one other time when the earnings yield line was above the bond yield line: the last few months of the bear market in 2002 (which is circled on the graph). Stocks were probably at their cheapest in the summer of 2006, when the gap between the two lines maxed out. Since then, stocks have enjoyed a nice bull run, so the gap has been closing modestly. But just in the last month, that gap has seriously widened again.
We never pretend to know where the market is going in the short-term. There could yet be another leg down as the market continues to assess just how badly the economy (and especially the financial sector) will be hurt by the subprime mortgage debacle. But we do believe there is a great deal of value in stocks right now for long-term stock investors.