Let’s start with the “scary” chart — the earnings yield vs 10-Year Treasury yield (see Chart 1). Earnings yield (the inverse of PE) has been falling with the equity market rally while bond yields are rising on the back of higher inflation. Since late-2023, the gap between the two has almost vanished — and this, according to the bears suggest that investors are not being paid the required premium to hold risky stocks instead safer government bonds. Historically, expensive stocks relative to bonds will eventually correct, that is, stock prices must fall.
The S&P 500 Index is now near its all-time record high, fuelled by investor exuberance for artificial intelligence-themed stocks. Stock prices — and valuations — have continued to rally, despite high oil prices, which are driving up inflation, and longer-dated interest rates. Rising headline valuations are, in turn, fuelling concerns that stocks — and, even more so, tech stocks — are overvalued. Warnings of rising risk of a bubble burst have been growing louder. Therefore, the obvious question is, are stocks excessively valued and is the market poised for a big correction? (Read the sidebar, “The math behind stock valuations”, which uses a simple math equation to explain the directionality of the US equity market over the past few decades, including current market valuations.)
