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Equities are still cheap

With February data now available, I've updated these charts covering equity valuation. As the first chart shows, the 12-month trailing PE ratio for the S&P 500 is still meaningfully below its long term average. This is remarkable, since a) Treasury yields are very close to all-time lows, so equity multiples should, all other things being equal, tend to be near all-time highs, and b) corporate profits according to the NIPA are at all-time nominal highs and all-time highs relative to GDP. This all points strongly to equities being underpriced and therefore quite attractive, provided one is reasonably optimistic about the future.

The second chart compares the earnings yield on equities to the yield on BAA corporate bonds. It is rare for the equity earnings yield to be greater than corporate bond yields, since this reflects a very pessimistic assumption on the market's part. You would only pass up a 7% earnings yield on stocks in favor of a 5% yield on corporate bonds if you thought that the outlook for earnings was dismal, and you therefore wanted to lock in a 5% yield with first claim on those earnings.

Looked at another way, corporate profits, according to NIPA data, have increased over 150% since 1999, but the S&P 500 index is essentially unchanged. Message: nobody trusts these profits to last; at the very least the market is priced to a huge mean-reversion in profits. So if profits just stay flat and/or fail to collapse, the equity market is going to have to rise considerably. As it is, S&P 500 profits are up 14.7% year over year, and up at an almost 20% annual rate in the past three months. This market is still very pessimistic. If you hold any hope for the future, equities are still very cheap.

Full disclosure: I am long the equity market at the time of this writing.

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