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Equities not so expensive

04072019_Equities expensive

Equities not so expensive

Ahead of the July 4 holiday here in the US the local stock market has closed at a record high. But shares may not be any more expensive on average than they have been over the past decade.

The afternoon of the 3rd of July, the S&P500 index, a broad measure of stock prices in the US, closed at an all-time high 2,996 points. In the chart below we can see that the rise to this point over the past 10 years has been almost uninterrupted (with the obvious exception of a slip in the last few months of last year). Presented with this data it would be easy to conclude that equities are expensive. However, when viewed in the context of interest rates over this period the picture is different.

S&P500 Index over the last 10 years

Screen Shot 2019-07-04 at 9.10.23 am

Source: Bloomberg

To do this I have taken the 10-year US government bond yield and compared it with the earnings yield of the S&P500. The bond yield is a representation of the risk-free rate or the long term annual return an investor can achieve without taking any risk of default or loss of notional capital (of course the US government can always make good on its promise to repay by taxing more, so the theory goes).

The earnings yield is the inverse of the forward PE of the S&P500 and reflects the annual rate of return generated by investing in a broad basket of US shares. The amount by which the earnings yield exceeds the bond yield can be thought of as the additional return being offered by (risky) shares over and above the (riskless) government bonds. This is shown in the chart below.

Premium of S&P500 earnings yield over 10-year US government bond yields over the last 10 years

Screen Shot 2019-07-04 at 9.11.06 am

The return premium offered by equities over government bonds has averaged 3.9 per cent in the US over the past decade. This is shown by the black dotted line in the chart. Coincidentally, the equity premium today is not far off this long run average, at 3.6 per cent. This means that equities are not more or less expensive (relatively speaking) at their new high than they have been throughout their decade-long rise to that point. Happy Independence Day.


Christopher is a Portfolio Manager for the Montaka funds and the Montgomery Global funds. He joined MGIM at establishment in 2015.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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  1. andrew ronan

    So when treasuries are yielding minus %5 and stocks are yielding minus %1 wil they still be fair value?
    Don’t laugh, that may well be the case in the near future if inflation starts moving and the focus is put on real returns after adjusting for inflation.
    When negative returns are seen as acceptable we have arrived at full insanity.

  2. But Roger, on many other metrics such as the Buffet metric, Coppock ratio, CAPE and reading other investment publications, they ARE very overvalued.

    Saying that they’re cheap relative to low interest rates that are forcing bonds to be losers and in this hype of tech stock unicorns that make no money, it’s dangerous.

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