Fortune -- At Thursday's confirmation hearing for Janet Yellen, the nominee to be the next Federal Reserve chairman was asked whether she thought there was a bubble in the stock market.
Yellen gave a pretty clear answer: No.
"Stock prices have risen pretty robustly," Yellen said. "But I think that if you look at traditional valuation measures, you would not see stock prices in territory that suggests bubble-like conditions."
Perhaps Yellen should have been even more bullish.
There are a number of ways to judge whether stocks are overvalued or undervalued. But the one most associated with the Fed -- it's nicknamed the Fed model -- is to compare the stock market's earnings yield, which is earnings/price or the inverse of the popular price-to-earnings multiple, to the interest rate on 10-year Treasuries.
The stocks in the S&P 500 (SPX) are expected to earn a collective $119.19 a share over the next year, according to FactSet. Divide that by the S&P 500's recent 1792, and you get an earnings yield, essentially how much the average stock is expected to return in income a year, of 6.8%.
The idea is that if you can get the same expected return from bonds, which are generally considered lower risk, buying stocks makes little sense. As bond yield approach stock yields, sell. On the flip side, when stocks yield more than bonds, buy.
The Fed has never officially blessed the model. But Greenspan referred to it regularly, and Yellen's comments on Thursday suggest she looks at bond yields when valuing stocks as well.
The rate on 10-year government bonds is 2.7%. That means stocks are not only cheap, they're a screaming bargain.
Critics would contend that the Fed model is meaningless right now. The Fed has been artificially driving down interest rates. That's what's making stocks look cheap.
But even before QE, some strategists thought the Fed model was flawed. Stocks and U.S. government bonds have different levels of risk. So back in the 1980s a number of prominent strategists contended that what you really needed to do was compare the earnings yield of the market to the expected interest rate on AAA-rated corporate bonds. Best guess for that is 4.9%, according to Randell Moore at Blue Chip Economic Indicators, which polls economists. So by that measure stocks are still cheap, but not by nearly as much.
Back in the '80s, though, lots of U.S. companies were rated AAA. Few are today. The most common rating for U.S. corporate bonds is BBB+, one notch above junk. The expected yield on those bonds is 5.9%. Use that yield, and we're not that far away from where the Fed model starts flashing sell.
We might get there pretty soon. When the Fed slows its bond buying, which most people expect will happen by the middle of next year, interest rates on all bonds are likely to go up, not just Treasuries. And corporate bond yields don't have to move up much before stocks go from looking cheap, to rather expensive. Bubble territory is not as far away as it looks.
Some economists are worried that farmland prices are nearing bubble territory. How bad can it be if no one's heard of it?
FORTUNE – Following the collapse of U.S. home prices in 2007, analysts and economists have been eager to spot the next big bubble. There's been talk of a bond bubble. And as U.S. stocks hover near a five-year high, many have wondered if a bubble is in the works. MORENin-Hai Tseng, Writer - May 10, 2013 5:00 AM ET
Is Wall Street's savviest trading firm leaving a LinkedIn fortune on the table?
The LinkedIn (LNKD) buying frenzy Thursday is a windfall for most of the business networking company's longtime shareholders, led by founder Reid Hoffman and his private equity backers.
The 115% surge in LinkedIn shares at midday Thursday sent the value of Hoffman's stake, for instance, soaring from a merely huge $852 million to a surreal $1.8 billion.
But one sizable MOREColin Barr - May 19, 2011 12:53 PM ET
Would you believe the value of LinkedIn has risen 19-fold in just over two years?
You must if you are planning on buying into its initial public offering. LinkedIn is expected to go public this week at a price above $40 a share. That's a far cry from the $2.32 a share the networking-for-professionals outfit valued itself at as recently as the spring of 2009.
That said, the company admits in offering MOREColin Barr - May 17, 2011 1:03 PM ET
Looking for a bubble? Look no further than the U.S. stock market.
So says value investor Jeremy Grantham. He warns in his latest letter to investors that stocks' liquidity-fueled cruise will end in a headlong collision with the rusty garbage scow of economic reality.
The result, he predicts, will be a plunge of 30% or so in the S&P 500, recently at 1340 (see chart, right).
Stocks are so inflated and so certain to MOREColin Barr - May 12, 2011 6:26 AM ET
Just how bubbly is the bond market, anyway?
It looks a little scary out there nowadays. High-yield bonds, for instance, are trading at low yields. The effective yield on the Merrill Lynch High-Yield Master II index -- tracking bonds issued by sub-investment grade companies -- dropped to 6.88% this week.
The last time it was that low was December 2004. It is an odd-looking milestone, considering that the unemployment rate then was 5.4% MOREColin Barr - May 11, 2011 6:25 AM ET
If the party goes on long enough, bubbly debt markets can make even toxic housing assets look tasty.
That explains why the AIG (AIG) bailout, long an albatross for Ben Bernanke & Co., is on the verge of producing an actual cash-on-the-barrel profit for the Fed – while lighting up dollar signs in the eyes of Wall Street.
AIG offered this month to buy back a portfolio of troubled mortgage bonds. Reports MOREColin Barr - Mar 25, 2011 12:54 PM ET
If you thought Goldman Sachs had a crystal ball, boy are you ever wrong.
The Financial Crisis Inquiry Commission today released more interviews and documents backing the 550-page report it released last month on the financial crisis.
Among those documents is a letter Goldman (GS) sent the commission in response to questions the FCIC posed last January and February. The FCIC letter includes a section (see question 22) in which high-profile financial writers MOREColin Barr - Feb 10, 2011 3:53 PM ET
The bull market in bonds isn't dead – it's just taking a nap.
So says Gluskin Sheff economist David Rosenberg. Unlike many investment strategists, he views the recent selloff in Treasury bonds not as a sign of an inflationary fixed-income apocalypse, but as the latest opportunity to buy income-generating bonds cheaper.
What's more, Rosenberg says the current obsession with rising food and energy prices will pass -- and along with it the market support for stocks at what he MOREColin Barr - Feb 7, 2011 12:17 PM ET
Muni bonds don't exactly turn heads when times are good. But lately they are getting a lot more attention than their embattled fans would like.
After rising through the first 10 months of 2010, the average municipal bond fund has lost 3% in just the past month, according to TrimTabs. Some funds have lost 10% or more this fall, as the long bull market in Treasury debt has come up lame MOREColin Barr - Dec 17, 2010 7:05 AM ET
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