Shine Investment Advisory Services

Last week, the Federal Reserve announced their plan to buy $400B of longer dated Treasury securities while selling an equal amount of Treasury securities with maturities of three years or less. In doing so, the Fed hopes to reduce longer-term interest rates.

Federated Investors’ Chief Market Strategist, Philip J. Orlando, made the following comments about the newly announced Fed initiative some are calling “Operation Twist” and its potential impact on stock prices.

Our research friends at Standard & Poor’s and Citibank published studies recently that detail this phenomenon. The Fed is hoping to make long-term interest rates sufficiently unattractive, such that investors look elsewhere and are willing to assume greater risk to realize better total returns.

• S&P dividend yields are higher than Treasury yields On a quarter-end basis, Standard & Poor’s reports that there have been 20 instances since 1953, in which the S&P 500’s dividend yield has exceeded the yield on the benchmark 10-year Treasury note.  In each instance one-year forward, stock prices were higher, by an average of 20%.  Today, the dividend yield on the S&P 500 is 2.28%, compared with a 10-year Treasury yield at 1.67%.

• Earnings yield gap differential Citibank studies the earnings yield gap differential between the benchmark 10-year Treasury note and the inverted trailing 12-month Price/Earnings (P/E) ratio of the S&P 500. With actual earnings per share of $83.77 in 2010 at the current price of $1,114, the resulting P/E of only 13.3 times inverts to an earnings yield of 7.52%. Compared with the current Treasury yield of 1.67%, that translates into an undervaluation for stocks of 78%, which is as cheap as stocks were at the bottom of the Great Recession in March 2009.  Moreover, Citibank concludes that this near three-standard-deviation reading has occurred in 61 prior weeks over the past 40 years.  In each instance one year forward, stocks were universally higher with an average return of almost 25%.

• Market technicals The 9% correction in stocks over the past three days brought the S&P 500 back down to 1,114, which is very close to our near-term technical target of 1,100.  It’s been our forecast that the S&P would need to successfully re-test the 1,100 level, which it hit on August 9, before it could make a serious run at breaking out of its current 1,250-1,100 channel. If 1,100 fails to hold, the next could technical support level is at about 1,035.