By Arnold Kling
If you believe in efficient markets, then you should be very skeptical of the rest of this post.
Ohio State’s J. Huston McCulloch, a leading authority on bond pricing, said on 2003-01-31,
Frankly, stocks are so reasonably priced relative to earnings at present, and real rates on TIPS [inflation-index Treasuries] are now so low, that stocks are more likely than not to generally outperform TIPS, for a change, in 2003. TIPS are essentially risk-free, however, still making them a worthwhile portfolio component. Nominals [regular Treasuries], on the other hand, have a smaller expected return than TIPS, according to the great majority of the SPF [inflation] forecasters cited above, but more risk, and therefore should be avoided entirely at this time.
Last October, I proposed a way to arrive at a fair value of the Dow Jones Industrial Average on the basis of the real yield on Treasury-indexed securities (TIPS), the dividend payout rate, and a forecast for dividend growth.
The required dividend yield for stocks is the difference between the real interest rate and the real dividend growth rate, or 3.0 – 2.0 = 1.0 percent. The ratio of the dividends on one unit of the Dow Jones Industrial Average to the level of the Dow should be one percent. [PIMCO’s Bill] Gross estimates that one unit of the Dow yields $185 in dividends. If the dividend yield were 1.0 percent, then the intrinsic value of the Dow should be 18,500.
Why is the Dow not at 18,500? Because of the margin of safety. Nobody wants to pay the intrinsic value for stocks. They want to pay less than that, in order to have a margin of safety. [Benjamin] Graham himself sometimes spoke of a 50 percent margin of safety, meaning that if the intrinsic value is 18,500 one might be willing to pay 9,250.
At that time, the Dow was around 8000, and this past Friday it closed at around 7900, which is about the same. However, since last October, one of the variables in the calculation clearly has changed. The real yield on the 30-year Treasury-indexed security, as tracked by Bloomberg, has fallen to 2.30 percent. Putting this into the equation above gives:
Dow intrinsic value = 185/(.023 – .020) = 61,600 (!)
The “margin of safety” is now over 80 percent.
Since October, I believe that the near-term outlook for real economic growth has dimmed somewhat. Thus, it may no longer be appropriate to use the figure of 2.0 percent for expected dividend growth.
More important, as I wrote in the essay cited above, I believe that in October that TIPS were underpriced. Their prices now may be more reasonable. In any event, their yield has come down.
For Discussion. Compared with bonds, are stocks really as cheap as they appear to be?