U.S. stocks near all-time low valuation compared to Treasury rates . . .

I have updated the calculation of the degree to which stocks are undervalued relative to the 10 year Treasury rate.  The earnings yield on the S&P 500 (reciprocal of the P/E ratio) recently exceeded the yield on the 10 year Treasury by 6.4 percentage points. This was a record spread as can be seen in the first chart below.  Wide spreads are associated with periods of extreme undervaluation of stocks which is calculated in the 2nd chart.  The S&P 500 is over 70% undervalued.  We have never seen this degree of undervaluation.  The reasons for the extreme undervaluation of equities can be debated.  The set of circumstances that will force the relative valuation to return to a more normal level can also be debated.  The math however is straightforward.  Either interest rates go up a lot, earnings come down a lot or equity prices go up a lot or some combination of all three must occur.  If history is a guide, we won’t have to wait long to find out which variable(s) change the most. History suggests that equity price appreciation is the dominant variable and that it goes up significantly in the next 180 days following a spike in the degree of undervaluation.  Jeb Terry, Sr. Dec 13, 2011

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