Darda calculated the ‘earnings yield’ by taking the inverse of his current market multiple of 11, which is based on the trailing four-quarters corporate profit data released in the GDP report. This method is similar to the ‘Fed Model’ allegedly used by Alan Greenspan, which took the earnings yield and compared it to government bond yields.
"We thus continue to believe stocks have overshot to the downside and that there is value in equities for investors with horizons beyond seconds, minutes, hours, days or weeks,” wrote Darda in the report. “The S&P 500 has fallen to valuation levels below those seen at the market lows in October 2002, October 1990 and December 1987. We’d be more concerned if the credit markets were in worse shape."
The model shows that corporate balance sheets and earnings power are in astronomically better shape according to bondholders than the equity market believes.
So why aren’t stocks taking off on this deal of a generation? For one thing, these models have been thrown off recently by a trend of compressing P-E ratios alongside falling interest rates. The 10-Year Treasury note yield fell below 2.9 percent today. In the past, when interest rates fell, investors were willing to pay more for the return potential in equities, and multiples increased.
It would seem equity investors are concerned more about macroeconomic factors, such as deflation and a possible double-dip recession, than actual earnings. Darda’s calculations show either stocks are incredibly cheap or earnings are about to fall off a clip because of some sort of macroeconomic event.
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John Melloy is the Executive Producer of Fast Money. Before joining CNBC, he was an editor for Bloomberg News, overseeing the U.S. Stock Market coverage team