Morgan Stanley picks up on the relative values of bonds and equities

US stocks had a bad day, finishing on their lows as US treasuries likewise fell, the yield on the ten-year US treasury now approaching 4%. We highlighted this week how the relative valuation between bonds and equities as measured by the equity risk premium had narrowed; Morgan Stanley picked up this point in a research report yesterday, stating that US equities, using this valuation matrix, could be 25% overvalued.

The maths to get there is simple. On 18x price to earnings, the earnings yield is around 5% (100/18), and the yield on the ten-year US treasury is 4%. To get to a historical gap of 3%, with current earnings forecast on the S&P 500, the earnings yield needs to be nearer 7%, a price-to-earnings multiple of 14X. Earnings forecast for the next year is approximately 210 dollars per share, around 3000 on the S&P 500, approximately 25% below where we are now.

What could change, yields on US treasuries could fall, helping to widen the gap, or corporate earnings could do better. If, for example, earnings on the S&P 500 grew this year by 10%, which is currently not forecast, and does seem an unlikely scenario in today’s economic climate, that could justify the current level of the S&P 500. The Yield on the US 10-year US treasury would have to fall dramatically to justify today’s level for the S&P 500 with no earnings growth. What may happen is a bit of both; yields start to fall as the Fed becomes less hawkish and earnings forecasts become slightly more optimistic.

There was good economic news from the flash purchasing manager surveys for leading developed economies, including the UK. The US January flash manufacturing PMI of 47.8 was better than the 47.1 expected, and services at PMI of 50.5 against the 47.2 expected. As for the UK, the composite reading combining services and manufacturing rose to 53, back in expansion for the first time since last July. The conclusion will be that developed economies remain resilient, and financial analysts will be pushing out their forecasts for when the next recession is likely. The good news for the government was not left there as we had an unexpected budget surplus in January thanks to a strong income tax receipt. In theory, this could give Mr Hunt a little more leeway as he prepares to deliver a budget statement next month. However, he seems to want to stick to the script of continuing, particularly with the rise in corporation tax.