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Goldman Sachs told its clients to ignore a widely-followed way to value the stock market used by Warren Buffett.
“With interest rates near multi-century lows, the so-called ‘Fed model,’ which compares earnings yields to bond yields, retains a powerful grip on the ‘valuation narrative’ in the equity market,” strategist Charles Himmelberg wrote in a note to clients Wednesday. “But yield comparisons across equities and bonds are a flawed metric.”
The strategist cited how the 10-year Treasury yield is at 2.2 percent and the S&P 500 earnings yield is currently at a more attractive 4.3 percent on the surface. The earnings yield is calculated by taking earnings per share for the index as a whole and dividing it by the price.
However, Himmelberg noted the valuation model doesn’t include any adjustments for future inflation and corporate earnings growth.
Goldman adjusted for those two factors using its analysis and found the historical yield gap, which measures how cheap stocks are versus bonds since 1961, fell from 74th percentile to only 7th percentile after the changes.
However, Warren Buffett would likely disagree with Goldman’s conclusion. He told CNBC in May how he uses bond yields to assess the market’s valuation.
“The most important item over time, and valuation, is obviously interest rates … The bogey is always what government bonds yield,” Buffett said in the interview, according to a transcript. “I would say that anybody that prefers bonds to stocks is making a big mistake … Stocks will bounce around a lot more and they can go down 50 percent, but a 30-year bond can go down 50 percent too. At these rates, bonds are a terrible choice against stocks.”