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Dressing Right

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Germany has made some moves toward convergence of euro fiscal policy -- a necessary step to save the common currency. A monetary union without a fiscal one has damaged the European economy. Germany capitulated on two key points, allowing: (1) European funds to be used to directly recapitalize banks and (2) bailout funds to be used to buy sovereign bonds on the open market.

This is a start but hardly a finish. In order to maintain the euro, Germany eventually must cede fiscal control to a pan-European authority. The moves so far have established a trend. Germany will soon be in too deep to turn back -- the necessary prerequisite to push through the politically unpopular idea of "eurobonds" backed by the full faith and credit of all euro nations -- at least those who are solvent (read: Germany).

Like a leader with an unwilling band of explorers at dusk, Merkel is hacking her way past the point of no return. Each step further into the unknown jungle is the best insurance against backtracking, if only because the terrifying path ahead is better than returning by nightfall.

The Dow rallied 270 points on the news because euro collapse was already priced in. When the surprising capitulation of Germany offered a partial solution, markets rallied to catch up. Europe still has terrible problems: an uncertain path to convergence against a backdrop of crushing austerity, rising unemployment levels in the peripheral countries with attendant social unrest, and the return to recession as lending once again recedes.

But stocks have priced in these conditions as well. Incredibly, stocks haven't been this cheap since 1921.

The best way to measure stock valuation is based on cash flows, not earnings, because cash flows are real money while earnings are the result of accounting manipulation. Cash flows have trended higher than earnings throughout the past five years because earnings reflect non-cash charges (such as goodwill write-offs), accounting "fictions" that have no bearing on the real money being earned by corporations. Even on an earnings basis, stocks have rarely been this cheap relative to interest rates.

If you invert the price-to-earnings ratio (P/E), you get the earnings yield -- the measure of the full dollar return you get from investing in any given share. Even after the rally, the S&P 500 is at a P/E of 13, which is an earnings yield of (1/13 = 7.69 percent). If you invest in the S&P 500, the companies you buy are receiving earnings equivalent to 7.69 cents on the dollar. If stocks paid out all this money to you as a shareholder via dividend, you would get 7.69 percent on your money. Obviously, companies do not pay all this money out: they reinvest much of it in the business, or use it to buy back stock. But both these alternate uses of money should accrue at least the same value to shareholders -- if done prudently by competent management (an "if" worth worrying about).

If we use the same approach the Fed uses to measure stock valuation -- comparing the earnings yield to prevailing interest rates -- we can see how cheap stocks really are. The "Fed Model" subtracts the three-month Treasury bill rate from the earnings yield to derive a "spread" measuring the excess yield of stocks over bonds. Currently, three-month bills yield 0.09 percent while the earnings yield is 7.69 percent. If we subtract 0.09 percent from 7.69 percent, the result is 7.60 percent, an extraordinarily high spread and one not reached during even the darkest days of the '70s.

You have to go back to the Great Depression to find spreads in the 7+ range and back to the 1914-1921 period to find spreads that exceeded 8 percent for any protracted length of time. In nearly every rolling five-year period following a spread exceeding 7 percent, stocks outperformed bonds by a massive amount, often by double-digit annualized returns.

Many pundits ignore prevailing interest rates when considering P/E ratios. This is like preparing for the day by looking at the humidity but not the temperature -- one less step perhaps, but surely a bad way to get dressed.