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After a brutal three-year bear market to begin the 21st century, US stock markets have done well four years in a row. In spite of this fact, stocks (especially large-caps) remain a great buy.

I come to this conclusion for several reasons. First, the valuation on the S&P 500 index has fallen for three years in a row even though stock prices have risen. This is because earnings have risen more quickly than stock prices.

According to Briefing.com, the trailing 12-month price/earnings ratio on the operating earnings of the S&P 500 has fallen from 18.3 two years ago, to 16.6 one year ago, to 16.0 today. The 12-month forward p/e is about 15, implying a 6.7 per cent earnings yield.

By contrast, the 10-year yield on US Treasury bonds is about 4.7 per cent. Not only are bond yields two percentage points lower than stock yields but this yield is the best you will ever get if you buy a Treasury bond today because bond interest payments do not rise over time.

Not true for stocks. The earnings yield on your original purchase price will rise, so that the yield on today’s purchase price will be higher in the future than it is today. If you were to buy both an S&P 500 index fund and a US Treasury bond fund today, the discrepancy between the earnings yield on your stock portfolio and the interest yield on your bond portfolio would rise over time.

For example, say you buy the S&P 500 index at today’s earnings yield of 6.7 per cent, and the operating earnings of the companies in the S&P 500 rise 6 per cent a year, on average, over the next 10 years. By year 10, the earnings yield on your original purchase price will have risen to 11.9 per cent. The interest payments on the Treasury bond will stay the same, so the pre-tax yield on your cost basis will be the same: 4.7 per cent. It can never rise from that level. Thus, the discrepancy between the earnings yield and the bond yield will rise from its present 2.0 to 7.2 per cent in year 10.

Stocks offer another advantage – the ability to defer capital gains taxes until a time of your choosing (this isn’t relevant if you’re a tax-exempt investor). Since most of the gain on stocks comes in the form of capital gains, you get to choose when to pay the taxman. Sell a stock and you pay taxes on your gain. Hold on to it and you don’t. Treasury bonds don’t give you this option. You have to pay taxes each year on the interest payments at ordinary income rates. If you’re in the 32 per cent tax bracket, the after-tax yield on a 4.7 per cent bond falls to 3.2 per cent. By contrast, the earnings yield on a stock is already converted to an after-tax yield because the earnings yield is calculated based on after-tax profits.

Some would argue that even at stocks’ current trailing p/e of 16, they’re selling above their post-second-world-war average valuation of about 14.5. That’s true. However, there is good reason to believe that the long-term average is skewed low. Interest rates in the 1970s and 1980s were far higher than they are today, while confidence in the Federal Reserve’s ability to manage inflation was far lower. The Fed has grown better at controlling inflation and telegraphing its thoughts on this subject to market participants. This has increased investor confidence in Fed policy, theoretically lowering the “risk premium” built into stocks. If investors don’t have to worry about runaway inflation, the future expected real (after-inflation) earnings yield on stocks should be higher. Inflation is the killer of p/e ratios. Remove significant worries about inflation and p/e ratios should be higher, all else being equal.

And finally, American corporations today have the best balance sheets in recent history. Debt-to-equity ratios are quite low by historical standards, free cash flow has soared, and many management teams are operating their businesses for cash flow rather than raw earnings growth. Today there is too much cash chasing too few investment options, so companies are buying back boatloads of shares on the open market. Simple supply-demand theory would conclude that with fewer shares outstanding across corporate America, and slowly rising investor demand for those shares over long periods, the aggregate p/e ratio should rise.

Sure, there is always a risk of a recession, which would cause the “e” in the p/e ratio to decline. That risk is always with us, especially after several years of an expanding economy. This is why investors demand a higher after-tax yield on stocks than they do on Treasury bonds. But today’s big gap between those yields seems excessive. Investors are being too cautious.

And that means this is a great time to buy stocks.
Mark Sellers is a hedge fund manager with Sellers Capital in Chicago. msellers@sellerscapital.com

Copyright The Financial Times Limited 2017. All rights reserved.
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