Equities in general and value spreads in particular remain attractive, and history would suggest that we are in the early innings of the value cycle. The next leg up is likely to be driven by earnings increases in the context of a modest economic recovery.
EQUITIES STILL UNDERVALUED; VALUATION SPREADS ATTRACTIVE
Broadly speaking, equities continue to appear undervalued globally, although certainly not at the generation-low levels we reached back in March. Our dividend discount model for the U.S. equity market - Figure 3 - indicates that we are still at a 29% discount to fair value. This model is sensitive to the current interest rate on treasuries. Interest rates would have to rise by over 200 basis points to 5.75% (a level not seen since 2000) for our model to indicate equities are fairly valued.
In addition, value spreads continue to be attractive. Figure 4 shows the spread between the valuation of the market's cheapest quintile and the market average for the U.S. Figure 5 shows that the price-to-book of the MSCI EAFE cheapest quintile is also attractive. The combination of broad market undervaluation and attractive value spreads give us reason to believe that there is still a significant opportunity for value to continue its run of outperformance.
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