Time to read: 3 minutes | 

In recent months, we’ve spent time explaining the difference between absolute and relative valuations to our clients. The distinction is important when making investment decisions.

An absolute valuation compares the price of an investment to another element of its value. For example, a company’s stock might be expensive relative to its earnings, book value, or dividend yield.

Relative valuations compare one investment or asset class to another.  For example, stock market dividends may generate higher current income than alternative assets, such as bonds or real estate.

It’s our opinion that markets today are at an unusual point in history. The U.S. stock market is beginning to look expensive on an absolute basis. However, as the second chart below illustrates, the market is still reasonably priced when compared to bonds:

The lower portion of the chart looks at the price of the S&P 500 divided by the book value of the index itself. The chart demonstrates it has moved into the overvalued section, which isn’t necessarily concerning. During much of the late 1950s and throughout the 1960s, the S&P 500 was highly priced relative to book value. The U.S. stock market achieved healthy rates of return as low interest rates made equities relatively more attractive.

The chart below shows the percentage of companies in the S&P 500 with dividend yields greater than the 10-year treasury yield – a telling relative valuation metric.

This chart illustrates how, historically, a large percentage of stocks pay dividends greater than the 10-year treasury yield, which makes them look relatively more attractive than bonds.

When absolute and relative valuations align, investment decisions may become clearer. When they conflict (as they do now), we think it’s best to look at relative value and closely watch for changes. We continue to follow objective indicators and will maintain flexibility for adjustments. More importantly, we’ll spend whatever time is necessary to ensure each client’s risk profile matches his or her investment plan and portfolio.

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.