With stocks near record highs, many are starting to worry that valuations have gotten too rich for the market's own good. But one influential economist is saying investors need not worry, and he has a 45-year chart to prove his point.
The S&P 500 is now trading at the highest price-to-earnings (P/E) multiple that stocks have seen in a decade, roughly 22 times its last 12 month's earnings, according to data compiled by S&P Capital IQ.
However, according to economist Alan Reynolds, senior fellow at the Cato Institute, the market shouldn't be looking at P/E in a vacuum. Instead, he maintains the key indicator is earnings yield—the inverse of the P/E ratio—and how it moves with interest rates.
"It makes no sense to say that stock prices are too high unless you also say that bond prices are too high," said Reynolds, who was part of President Reagan's OMB transition team in 1981. "I think bond prices are too high but so does the stock market."
Reynolds has graphed the S&P 500's earnings yield against the benchmark U.S. 10-year Treasury note going all the way back to 1970. He found that earnings yields track quite closely with bond yields. And since yields move in the opposite direction of price, the prices of both stocks and bonds have risen steadily over the past few years.