Using another old, largely discredited model of the reasonableness of US stock prices, the Fed Model, which compares the "earnings yield" (i.e. earnings-to-price ratio) of the S&P 500 (5.89%) with the yield on the 10-year Treasury note (5.12%), stocks look a bit undervalued. Of course one of the reasons the Fed Model has been dismissed in recent years was the distortions to the 10-year's yield resulting from a global liquidity glut.

Taking a tack similar to the Fed Model, and comparing the S&P's earnings yield (5.89%) with today's aggregate yield of 10-year AAA-rated corporate bonds (5.92%), we get almost an even match in yields.

Obviously, with the rise in their yields, bonds seem a much better bargain today than they were with the 10-year Treasury at 4%. Are they as good a bet as US stocks? The uncertainty strengthens the case for diversification between stocks and bonds, and that case is much stronger than it has been in the recent past.

Mr. Perold said the key point of his paper is that if nothing is known about fair value, then any stock, regardless of capitalization, is just as likely to be overvalued as undervalued. Consequently, holding stocks in proportion to their market capitalization doesn’t systematically result in performance drag, he said.

Quant managers who have seen Mr. Perold’s paper say it’s a strong argument. To make the case for fundamental indexing, you have to presume that “large-cap stocks are overvalued, and you don’t know that,” said Eric H. Sorensen, president and chief executive officer of Boston-based PanAgora Asset Management Inc.

On that note, I can't recall whether it was Benjamin Graham or Warren Buffett who said, "God almighty doesn't know the proper price-to-earnings ratio for a common stock." Maybe it was Burton Malkiel. Probably all three of them said it at one point or other. But that's not going to stop me from pointing out that, based on its historical mean P/E ratio, the S&P 500 still looks to be fairly valued at its current level, if just a little pricier than a couple months ago.

True, stock prices have risen, but so have trailing earnings and estimates of future earnings.

Today the S&P 500 closed at 1451.19. Assuming a fairly conservative ("as reported") estimate of aggregate earnings of $92.25 for the index, that gives us a Price-to-Earnings (P/E) ratio of 15.73, right in line with the historical average of 15.68 since 1935.

Say we get a little harsher in evaluating earnings, and go with an S&P "core" earnings estimate of $85.70 for 2007. We're still looking at at P/E ratio of 16.93 for the year, still quite reasonable, especially in a period of modest inflation and low interest rates.

Project the high quality of "core" earnings to trailing 12-months earnings measures, and the P/E creeps up a bit to 18.16. Sorry, but that's still not a bad P to be paying for all that E. Bob Shiller would surely disagree, given that he likes to calculate his P/E based on 10-year trailing "smoothed" earnings, but Ed Yardeni would point out that investors don't discount the past, they discount the future.

US large-cap stocks still look reasonably priced at this date. I'm squinting really hard, but I can't see a bubble there (though I can certainly still see bubbles in plenty of neighborhoods in bond world - sorry, is that mixing metaphors?). A correction may come, but it would represent, more than anything else, a buying opportunity.

Meanwhile Tom Adams has been kind enough to spell out what this morning's CPI report means for Series I savings bond investors:

December's CPI of 201.8 was up 2.5% from a year ago and it was up .15% from November's level. However, it's still below September's 202.9, which is the number I bond investors watch. That's because the I bond inflation component is based on the level of the CPI in March and September.

Investors already seem worried about the possiblity. Since the government's fiscal year began in October, new investments in Savings Bonds have barely recovered from the all-time lows seen over the summer.

This simple P/E-comparison method of stock valuation is just that: simple. More sophisticated schemes are used by the likes of the bullish Jeremy Siegel, who compares a variety of earnings metrics to a variety of bond yields and still finds US stocks undervalued. His perennial counterpart on the bearish side, Robert Shiller, uses a "10-year smoothed" trailing P/E and finds shocking overvaluation still baked into the US stock cake.

For the finance dilettante typing this, simpler is better. I think stocks are possibly a little overvalued at this point, after a period of undervaluation, during which it was very good to be on the buying side. And even with stocks a little overvalued, I am comfortable continuing to dollar-cost average into my array of stock index funds for the foreseeable future.

The dividend tax cut, which Siegel strongly championed, seemed at times to be the only policy consideration in the professor's line of sight. With the rest of the world crumbling around us, largely thanks to the Republicans in Congress and the neo-con-men and kleptocrats in the Bush Administration, hoping for continued rule by this gang of miserable failures solely for the continuation of a lower tax rate for stock dividends struck me as symptomatic of an acute political tunnel vision.

But this week sees the good prof. stepping up on Global Warming in an article for Yahoo finance, briefly excerpted below.

Clearly we must stabilize the levels of carbon dioxide in the atmosphere. Some suggest that it might cost 5% of GDP to do this, but most estimates are much lower, at 1% of GDP, or below. And actions to stabilize CO2 may not require a complete switch into solar, wind, nuclear, or hydrogen-based energy sources. The emissions from coal, the cheapest, dirtiest, and most abundant fossil fuel, can be harnessed by a process called “sequestration,” where emissions from coal plants are captured and stored underground.

I believe that to encourage such technologies, the U.S. and developing nations must take action. The U.S. now emits the most greenhouse emissions, but China and India will soon overtake us. That means that the U.S. must enact its own greenhouse measures (or renegotiate the Kyoto Accords) and use its clout to persuade China and others to participate.

Says Adams:

The Consumer Price Index fell during September to 202.9 from August's 203.9. The Series I Savings Bond inflation component is based on the level of the CPI in March and September. In March the index was at 199.8. This means the next I bond inflation component will be 3.10%.

To determine what your own I bonds will earn during their next six-month rate period, you have to add their fixed base-rate to 3.10%. The fixed-base rate for your I bonds can be anywhere between 1.0% and 3.6%, depending on when the I bond was issued.

Meanwhile, older variable rate EE savings bonds (those issued between May 1997 and April 2005) seem on track to earn about 4.4% come the November readjustment, given the recent relatively high yields on the 5 Year Treasury (these older EE savings bonds are pegged to 90% of the fiver's average yield for the six months preceding the readjustment).

Where Treasury will set the rate for new fixed-rate EE bonds is anybody's guess.

For decades economists and politicians have debated how to reconcile the undoubted power of markets with the reassuring protections of social insurance. America's supply-siders claim that the best way to achieve well-being for America's poor is by spurring rapid economic growth and that the higher taxes needed to fund high levels of social insurance would cripple prosperity. Austrian-born free-market economist Friedrich August von Hayek suggested in the 1940s that high taxation would be a "road to serfdom," a threat to freedom itself.

Most of the debate in the U.S. is clouded by vested interests and by ideology. Yet there is by now a rich empirical rec-ord to judge these issues scientifically. The evidence may be found by comparing a group of relatively free-market economies that have low to moderate rates of taxation and social outlays with a group of social-welfare states that have high rates of taxation and social outlays.

Not coincidentally, the low-tax, high-income countries are mostly English-speaking ones that share a direct historical lineage with 19th-century Britain and its theories of economic laissez-faire. These countries include Australia, Canada, Ireland, New Zealand, the U.K. and the U.S. The high-tax, high-income states are the Nordic social democracies, notably Denmark, Finland, Norway and Sweden, which have been governed by left-of-center social democratic parties for much or all of the post–World War II era. They combine a healthy respect for market forces with a strong commitment to antipoverty programs. Budgetary outlays for social purposes average around 27 percent of gross domestic product (GDP) in the Nordic countries and just 17 percent of GDP in the English-speaking countries.
. . .
On average, the Nordic countries outperform the Anglo-Saxon ones on most measures of economic performance. Poverty rates are much lower there, and national income per working-age population is on average higher. Unemployment rates are roughly the same in both groups, just slightly higher in the Nordic countries. The budget situation is stronger in the Nordic group, with larger surpluses as a share of GDP.
. . .
Von Hayek was wrong. In strong and vibrant democracies, a generous social-welfare state is not a road to serfdom but rather to fairness, economic equality and international competitiveness.

Kind of tough to argue with what his allies, like Santa Clara Prof. Meir Statman, are saying about the concept of risk:

"We've come to thinking about risk as standard deviation," Mr. Statman said. "What people want is protection when the economy tanks."

though it's also kind of hard to acquaint my tiny mind with Sharpe's new best friend "state-preference theory":

"The elegance of (the state-preference model) is that you can understand the elements of the various moving parts of the optimization," said Gifford Fong, editor of the Journal of Investment Management and president of Gifford Fong Associates, a Lafayette, Calif.-based consultant on fixed income and derivatives.

Investors can assign probabilities of any given state occurring. In a complete market, an investor can buy or sell a security for every possible outcome.

Guess I should put the book on my Christmas wish-list, squint real hard, and commence to cipherin'.

Meanwhile, Harry Markowitz isn't too terribly impressed, according to the same Investment News item:

"I find [the state-preference approach uses] a very general set of assumptions out of which very little specific can be deduced," said Mr. Markowitz. He and Mr. Sharpe will debate their differing views Oct. 16 at the Institute for Quantitative Research in Economics' 40th anniversary conference in Santa Barbara, Calif.

A tiny bit of perspective: The US stock market is doing well, but when measured by the S&P 500 (a much better measure than the price-weighted, Dow Industrial average of only 30 stocks), which closed at 1336.50, is still below its level of 1,342.90, where it was when George W. Bush took office. Even factoring into returns the S&P's annual dividend yield of 1.8%, an investor who bought an S&P 500 index fund on the first day of the Bush administrations would have failed miserably to even match the rate of inflation by yesterday's close.

The stock market has historically done much better under Democratic administrations than under Republican administrations, as Professor Jeremy Siegel himself a Republican booster (if only for the sake of his precious dividend tax cut), showed in the last edition of Stocks for the Long Run.

Forbes has noted that the US economy has historically done better under Democrats. And the Stock Trader's Almanac provides this handy comparison of the Dow under Democrats and Republicans:

DJIA, 1981 - 2004
Republican years Avg. annual change: 6.9%
Democratic years Avg. annual change: 13.3%

Right-wingers have nothing to crow about with regard to the level of US stock market. Yet they still crow. Remember: their community is not reality-based.

Atrios kindly points us to this Think Progress report that helpfully reiterates, in response to Fox News nonsense, that the Bush tax cuts have done nothing for the US stock market:

A 2005 study by four Federal Reserve Board economists “fail[ed] to find much, if any, imprint of the dividend tax cut news on the value of the aggregate stock market.” According to a Wall Street Journal article, the study concluded that Bush’s tax cuts were “a dud when it came to boosting the stock market.”

Analysts at the Tax Policy Center found that the link between capital gains tax rates and stock market growth is “weak” and capital gains have historically risen with “little apparent effect on the stock market.”

On the topic of Treasury yields and the famous curve that charts those yields across the range of maturities, the Dallas Fed has some interesting thoughts (via Economist's View)

I should have the year-to-date asset class returns updated shortly after month-end. That will provide even more perspective on what's happening in the race of returns between stocks, bonds, and other asset types.

As Negativland advised, shop as usual and avoid panic buying.

We should let Wal-Mart be Wal-Mart when Wal-Mart gets its hands out of our pockets. I want Wal-Mart to be in a free market, not get a free ride. We taxpayers are subsidizing Wal-Mart by providing benefits to their employees: We provide Medicaid, food stamps, Section 8 housing assistance, tax credits, and free and reduced-price school lunches. An August 2004 study by the University of Califromia Labor Center estimated that Wal-Mart cost taxpayers $86 million per year and that was just in California.

I will be happy to leave Wal-Mart alone when it pays its workers enough to keep them from taking my tax dollars. At that point, we'll be square. Yes, prices will then be higher at Wal-Mart. That's the free market.