Stocks have greater value than at any time during the past quarter century.  It may take a few years, but that value is likely to produce excellent returns for investors with a long-term horizon.

This is the first of a two-part examination of current market conditions and a comparison to 30 years ago.

Relative Real Value Is What Is Important ? But We Start with the Simple Measures

It is frequently noted that basic stock valuation measures are near historical levels.  This is true.  Here is a chart of the S&P 500 price/earnings (P/E) ratio over the past quarter century.

It is unfortunate that stock valuations are typically presented via the P/E.  It is a valid measure, but it is not intuitively clear what it represents.  A much better way to think of stock valuations is simply the inverse -- the earnings ratio (E/P). It is the exact same measure, but the earnings yield has clearly understandable implications.

Here is the E/P chart for the past quarter century.

Stocks presently yield over 7% based on projected 2011 earnings.  Again, this is reasonably consistent with historical norms.

The analysis continues with what is one of the most stunning charts of the past quarter century.  Below is the year-over-year core rate of inflation.

Inflation has declined steadily and is at extremely low levels.

It is not surprising that, given this inflation trend, the yield on the 10-year note has also trended lower during this period.

The Real Yield on Stocks and Bonds.

The historical earnings yield of E/P (or P/E) on stocks has no more meaning than the historical yield on bonds without including the impact of inflation.  Subtracting the inflation rate from the stock or bond yield produces the economically relevant "real" yield.

The real, inflation adjusted, yields on earnings and the 10-year Treasury note are presented below.

Relative Valuation

Assessing where to put money is critical to sound, real-world investing.  Investing in the proper asset class -- stocks, bonds, or cash -- is the most important aspect of achieving good investment returns.

One of the most important analyses in investing is therefore how stock valuations compare to bond valuations.

This is where it becomes apparent that stock valuations are appealing.

Below is a chart of real stock yields minus real 10-year Treasury note yields.  A positive value means that stocks provide a greater real return than bonds.

As can be seen, the real return on stocks approximated the real return on bonds from about 1985 through 1999.  During this period, which included many of the Greenspan Fed years, there was much talk about the "Fed model" for stock valuation.  That model proposed that the forward twelve-month yield on stocks should approximate the 10-year Treasury yield.

It is imprecise but not a bad starting point and worked well for over a decade from 1985-1998.

Then in 1999 and 2000 stock values rose sharply and the real yield on stocks dropped below bonds.  This analysis suggested that stocks represented poor relative value.  Stocks subsequently crashed.

From 2002 through 2007 stocks seemingly provided better relative yields than bonds, and of course for a while stocks ran strong.  This proved a false valuation signal, however, as the economy and the market encountered what was (literally) a once-in-a-generation credit crisis.  This produced the stock market crash of 2008. (This may well prove an aberration separate from normal business cycles which will not recur for many decades.)

The decline in stock values in 2008, however, also pushed the relative value of stocks to amazing levels not seen during your author's increasingly long career in the financial markets.

The S&P 500 is up 100% over the two years since stock valuations spiked higher as seen in the chart above.

The unusually large difference in stock yields relative to bond yields, sometimes called the risk premium, reflected fears prevalent throughout the investment world in 2008.  Those fears were built into stock prices, but precisely for that reason, produced what in hindsight was a once-in-a-lifetime opportunity.

Current Conditions

The relative valuation opportunity in stocks has declined the past two years given the recent huge stock market rally but nevertheless remains extremely high on a historical basis.

In fact, given the decline in risk in the economic and earnings outlook the past year, the reward/risk ratio is arguably better now than it was in 2009 when risk was higher.

Conclusions

The relative value in stocks is striking to your current author, who has been in the financial markets for over 30 years.  It reminds me of the situation in 1979 when I first entered the financial markets.

In 1979, everyone knew that stocks were a terrible investment.  After all, stocks had produced no gains over the prior 14 years!  My stock broker insisted in the early 1980s, however, that it was a "turkey shoot" for stocks.  I stuck with safer money market yields instead. The Dow was at 815 my first month of employment.

Everyone today also knows that stocks are a lousy investment.  The Dow is right where it was 12 years ago!  Young investors today have witnessed the crash of 2000-2001 and 2008.  Everyone knows that stocks are far too risky for the lousy returns offered.

That could continue to be true.  On the other hand, the relative value that exists in stocks today could well produce solid returns over the long term, particularly compared to bonds or cash.  The current high earnings yield relative to inflation and bonds will, as risks ease, decline, and produce good returns in stocks relative to other asset classes.

Below is an interesting long-term chart of the Dow.  The numbers below the yearly trend reflect a compounded annual growth rate.

The chart suggests that there may be generational cycles that impact long-term stock trends.

It also suggests that it may be a few years before a bull market returns.  That seems very reasonable.

It may take a few more years for the credit markets to fully clear and for credit expansion to develop. It may take a few years for the housing market to fully stabilize. It will also certainly take some time to address the imbalances in governmental balance sheets that the country faces.

Nevertheless, the history of the US and free market economies in democracies is that economic problems are addressed and that markets self-correct.

Given current conditions, it may be very hard for many that have experienced just the past decade of the financial markets to believe that another bull run will ever recur in the stock market.

That is exactly what I thought in 1979 when I first entered the financial markets. The stock market had been flat for 14 years and everyone absolutely knew, beyond any doubt, that stocks were a lousy investment.

That proved wrong, as did almost every single aspect of conventional wisdom from those bleak days.

Now may be exactly the right time for long-term investors to start accumulating stock positions, just as it was in 1979.

The next Big Picture column to be published in two weeks will continue long-term considerations with a retrospective on the changes that have occurred over the past 30 years and what that might imply for long-term investing today.