After recent sharp declines, US stock valuations look more attractive, especially compared with bonds. While the current volatility is unsettling, heightened uncertainty over earnings because of the coronavirus crisis could create opportunities for long-term investors who distinguish between winners and losers from the shock.
US equities were trading at nearly a 17% premium to their 20-year average before the recent correction. The rally that began in 2019 had pushed the price/forward earnings ratio of the S&P 500 up to a peak of 19.5× in mid-February.
How quickly things change. The Fed’s emergency 50–basis point rate cut on March 3 underscored mounting concerns about impending macroeconomic damage as the virus spread from China to the rest of the world. Even before the cut, fears emanating from the Chinese manufacturing slowdown threatened to destabilize earnings and sent stocks tumbling. In the US, the S&P 500 fell by 12.8% from the market peak on February 19 to February 28, the fastest correction of this magnitude since the global financial crisis.
Falling Bond Yields Flatter Stock Valuations
But bond yields have tumbled, too—and that affects the relative appeal of stocks. Lower rates provide two stimulants for stocks by reducing the cost of borrowing—which can be used by companies to enhance shareholder value—and by making dividends more attractive. Indeed, the 10-year US Treasury yield fell to 1.00% by March 3, versus the S&P 500 dividend yield of 2.01%. In other words, the S&P 500 now yields 101 basis points more than the US Treasury—a gap we haven’t seen since the global financial crisis (Display).
Relative valuations are also illuminating. The valuation of the 10-year US Treasury reached 100× on March 3, based on the inverse of the current yield, which estimates the price an investor pays for the income on the government bond. That makes the S&P 500 P/E of 17.4× look very attractive (Display, left). Looked at from another angle, the S&P 500 earnings yield of 5.8% dwarfs the US Treasury yield (Display,right). And within the US market, investors can find many stocks of companies with strong fundamentals, dividend yields well above 2% and growing dividends to boot.