US Equity market overvalued?

The Big Picture picked up on an article on Paul Krugman, entitled "The Deflationist", which appeared on The New Yorker yesterday. One line in the piece caught Barry Ritholtz's attention:

“Let’s put it this way. I can have fairly high confidence—it’s a personality thing—that a market is overvalued. Somehow I never have the same confidence in saying that it’s undervalued.”

Barry (of The Big Picture) thinks that the reason for Paul's confidence in overvalued market "has to do with who was running the Fed for most of your adult life: Some guy named Alan Greenspan" (here). To wit:

Consider the following two charts: The first chart shows the 1977-2007 period P/E ratio for the S&P500, highlighting the band of where stock prices would have been if the P/E ratio had stayed within one standard deviation of their long term average.

As you can see, for most of Greenspan’s tenure, as well as Bernanke’s (excepting the March ‘09 lows), stocks have been mostly-to-extremely overvalued:

Chart 1: S&P & the Market P/E (Source: S&P, Factset)

Barry further added:

The second chart is a chart of how much the consumer leveraged themselves up during Greenspan’s tenure: What they purchased in excess of their cash income:

Chart 2: Consumer Speeding in excess of Cash Income (Source: The Big Picture)

Regardless of your sentiment towards Greenspan or Bernanke, there is no doubt that the Fed's action which resulted in a steady drop in bond yield since 1985 has been one of the driving force that propelled the value of equity as well as other classes of assets (such as realty) higher.

Easy monetary policy in the past few years (prior to & after the Global Financial Crisis) has resulted in funds being deployed in commodity speculation, resulting in a sharp rise in prices of commodities, including food stuff. This put pressure on the inflation front, regardless on the slack in the production capacity. Once inflation picked up, it has a life of its own. The bond market is slowly pushing bond yield higher. From Chart 3 below, we can see that the breakout level of the present long-term downtrend line for 10-year bond is at 4.5%. If & when the bond yield surpassed its downtrend line, we would see a change in the behavior of equity & other asset classes. I have commented on this before (here).


Chart 3: TNX's weekly chart from 1962 to Feb 2010 (Source: Yahoo Finance)


Chart 4: DJIA's weekly chart from 1962 to Feb 2010 (Source: Yahoo Finance)