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If bond yields are so low, aren't stocks cheap?

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Toru Hanai/Reuters

(Read caption) People are reflected on a stock quotation board outside a brokerage in Tokyo Aug. 11. A decade ago, Japanese investors had much the same choice that Americans do today: buy low-yielding bonds or stocks. Guess who came out on top.

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Are stocks at current levels cheap or not? If you look at a historical comparison, the clear answer is "no", as the P/E ratio is above the historical average.

One counter-argument from stock market bulls is that bond yields are unusually low, which is to say the "P/E ratio" of bonds are unusually high.

It is true that all other things being equal, lower interest rates justify higher stock prices. But the flaw in the counter-argument is that all other things may not be equal. In particular, low interest rates might suggest low growth expectations, something which will depress investment demand for loanable funds. And if these expectations turn out to be true and economic growth is low or non-existent, then profits will be low, something which in turn will lower stock prices.

An example of this in practice is Japan, which in 2000 had even lower yields than America has today. The 10-year yield was for example less than 2% then.

Yet despite that low yield, you still would have been far better off buying that bond rather Japanese stocks, as the Nikkei index has dropped 43.6%, from 16,280 to 9,179 between August 20, 2000 and August 20, 2010. Including dividends would improve the relative performance of stocks somewhat, but not by much as dividend yields in Japan has typically been low (lower than bond yields).

This is not to say that stocks will necessarily fare as bad as in Japan as the U.S. economy might perform much better during the coming decade than the Japanese economy during the latest decade. But given how destructive economic policy has been that is far from sure. And the point is that there is no necessary negative link between bond yields and the attractiveness of stocks.

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