Determining whether price-to-earnings (P/E) levels in the stock market are relatively high or relatively low can be extremely difficult if you don’t know where to look. The problem is, most investors try to look inside the stock market to get an objective view of P/E levels. Instead, investors should be looking outside of the stock market and into the bond market, especially the U.S. Treasury market.

[VIDEO] How to Determine if P/E Levels Are High or Low

The bond market and the stock market are closely related because they compete for money from the same pool of investors — all of whom are extremely motivated to make a profit.

Searching for Higher Yields

Investors are always looking for the best return on their money. If they can find a better return in the stock market, they will put their money into the stock market. If they can find a better return in the bond market, they will put their money into the bond market.

Determining the yield on an investment in a bond, like the 10-Year Treasury yield (TREASURE10Y) for instance, is quite simple because the yield is published throughout each and every trading day. In fact, at the time of this writing, the yield on the 10-Year Treasury is 3.74 percent.

Determining the yield on the overall stock market, on the other hand, requires a little more effort.

Using the P/E Ratio to Find the E/P Ratio

You can determine the current yield of the stock market — measured by the S&P 500 in this case — by finding the inverse of the market’s current P/E ratio. After all, the inverse of the P/E ratio is the E/P (earnings-to-price) ratio, and the yield is nothing more than knowing how much the asset is going to produce divided by the price you are paying from the asset.

For instance, if you know an asset you pay $100 for is going to produce $10 in earnings, you know that asset will yield you a 10-percent profit ($10 / $100 = 10%).

So all you have to do to determine the yield on the stock market is find the P/E ratio for the S&P 500 [which can be found here] and then calculate its inverse.

For instance, at the time of this writing, the P/E ratio for the S&P 500 is 58.66. Now that I know that, all I have to do is find the inverse of this number to determine the yield on the S&P 500, which in this case is 1.7 percent (1 / 58.66 = 0.017).

Now, we don’t want to forget about dividends because they play an extremely important role in your overall profitability in the stock market. Once again, at the time of this writing, the dividend yield for the S&P 500 is 2.63 percent.

If you add the yield on earnings from the S&P 500 — which is 1.7 percent — and the yield on dividends from the S&P 500 — which is 2.63 percent — you get a total yield of 4.33 percent (1.7 + 2.63 = 4.33).

Interpreting P/E Ratios and Yields

As you look at these numbers, it is important you remember the following:

• As P/E levels increase, yields decrease
• As P/E levels decrease, yields increase

In other words, when we see investors who are willing to pay a higher price for a stock, we know they are willing to accept a lower yield on the current earnings of the company represented by that stock. In most cases, investors would only do this if they believed the future earnings of the company were going to increase or the future price of the stock was going to be driven higher by the market for some other reason.

Conversely, when we see investors who are only willing to pay a lower price for a stock, we know they are not willing to accept a lower yield on the current earnings of the company represented by that stock. In most cases, investors would only do this if they believed the future earnings of the company were going to decrease or the future price of the stock was going to be driven lower by the market for some other reason.

Putting it All Together to Assess the Current P/E Level

Now that you have all of your data — the 10-Year Treasury has a yield of 3.74 percent and the S&P 500 has a yield of 4.33 percent — you can assess whether the current P/E level for the S&P 500 is too high, too low or just about right.

In this case, the current P/E level shows us investors are gaining more confidence in stocks. Whether they believe corporate earnings are going to improve or that more money is going to be coming into the stock market and driving up prices, investors are showing they are willing to accept a lower yield and a lower risk premium — the difference between the yield they could get by investing in bonds compared to the yield they can get investing in stocks, which is 0.59 percent (4.33 – 3.74 = 0.59) in this case — right now.

All in all, it looks like the current P/E level of the S&P 500 is in a comfortable range relative to the yield on the 10-Year Treasury.

Image courtesy Jeff Keen.