Rauch: Overvalued

George Rauch: Overvalued

Here's my contention: The stock and bond markets are 30% overvalued based on their historic indicators and current ratios, creating investment risks in both markets.

BONDS

The 10-year U.S. Treasury note currently yields 4.51%. The ten-year Treasury bond is used to set almost all variable-rate mortgages and notes in this country. The long-term return on the Treasury bond is 2.8% over inflation. If one adds the current rate of inflation at 4.4% to the 2.8% that bonds have yielded above inflation over the last 50 years, the yield on the treasury bond "should be" 7.2%, or $72 per $1,000 bond. If the price of the Treasury bond dropped from $1,000 to yield $72 per bond, the treasury yielding 4.51% would drop in price from $1,000 to $626 per bond ($45.10 divided by 7.2%). In real dollars, the ten-year Treasury note is overpriced by more than 30%.

STOCKS

The historic Dow Jones Industrial Average (DJIA) price-earnings ratio is 14.4 times earnings. The current price-earnings ratio of 18.1 times earnings, adjusted to the mean, would find the Dow selling at 8,700 - 2,200 points below the existing market prices, or more than 20% below current prices. However, the historic cash yield on the Dow Stocks is 4.3%, and the current yield is 2.3%. The Dow, adjusted for a reversion to the mean based upon yield, would cause the Dow to return to 5,800 points (10,900 points x 2.3% = $251.00, divided by 4.3%). 5,800 is 49% below existing market prices. An average of where the market would be based, with both yield and price-earnings ratios, would reduce the 10,900 Dow by 35%, for an average price of 7,100 points.

Question: If that's true, doesn't the market currently bear a lot of risk?

Yes, the market is highly risky now. Not only is the market mathematically overvalued, but hanging over the market are all the economic dislocations Market Watch has been writing about: Record trade deficit; record federal deficit spending; loss of manufacturing base in the U. S.; high inflation; high energy prices; expensive housing, and record-high consumer debt - all coupled with a loss of higher paying jobs.

Question: Most Wall Street analysts are very upbeat and foresee good performances in the stock and bond markets over the next 12 to 24 months. Is that valid?

Wall Street analysts are too close to the forest to see the trees. Most analysts work for firms that deal in securities. More than 70% of the analysts believe the market is performing well and will continue to do so. Until this sentiment changes, it is not likely that the market will go down severely. However, the market can go sideways like it has been doing for years. Analysts are trying to convince the public to stay in the market. Market Watch is suggesting that it's wisest for investors to limit the percentage of money they have in the stock market. If one has invested in stocks in this market, an investor is far better off to invest in high grade, A-rated stocks selling at low price-earnings ratios and yielding more than 4%.

Question: If bonds were so overvalued, as stated above, why would anybody invest in them?

It's a complicated answer:

1. Since Greenspan took over the Fed, the money supply has grown from $2 trillion to $10.3 trillion, far out pacing GDP growth;

2. Household debt has increased from $1.8 trillion to $10.8 trillion, far exceeding the increase in wages;

3. During Greenspan's tenure, the purchasing power of the dollar has been reduced by 50%. Think about anything that you bought in 1982. It costs at least twice as much today.

All that money floating out there is going to be put to use. Quite simply, if it's not invested or spent on consumer items, it will be placed in treasury securities, now equal to $8.2 trillion, more than ten times the national debt during the Regan administration, when Greenspan became head of the Fed. Many institutions are required to keep a certain percentage of their money in the safest investments. And the safest investments are still U. S. Treasury securities.

Question: What can we expect, historically, out of the market over the next 10 years?

Right now, with 10-year-bond yields at 4.51%, we can expect, from a historical perspective, a 4.3% annual average gain (including dividends) over the next 10 years in the stock markets. That yield might keep us abreast of inflation.

Conclusion

The fourth quarter of the 2005 GDP advanced at a rate of 1.1%, less than inflation in the fourth quarter, and much less than the third quarter GDP increases of 4.1%. On the other hand, corporate earnings last year were excellent, with many corporations establishing new earnings records. The wily investors will bide their time, wait for better buys to become available in the stock market, and realize that patience in investing provides long-term dividends. With price-earnings ratios and yields having improved over the last six years, one is better off to be in short-term treasury securities or tax-free bonds, and limited percentages of stocks, with those stocks priced at, or below, their average historical price-earnings ratios.

George Rauch is a former Wall Street investment banker who lives on Longboat Key. He also writes on investments for The Longboat Observer.