"The potential downside to the Viper structure is the requirement that mutual funds distribute capital gains across all share classes. [VIPERs are just another share class of Vanguard open-end index funds.] While this theoretically creates an exposure to capital gains generated from other shareholder activity, Vanguard's management intends to use the creation/redemption process to distribute out capital gains. This potential exposure does not exist with the other forms of ETFs."
Some researchers believe that it is wrong to value stocks by comparing the earnings yield, E/P, with bond yields, because (quoting the following paper) "it compares a real number to a nominal number, ignoring the fact that over the long-term companies' nominal earnings should, and generally do, move in tandem with inflation." I have not reached a conclusion on this. Here are some references.
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the Fed Model: The Relationship Between Stock Market Yields, BondMarket Yields, and Future ReturnsCLIFFORD S. ASNESS AQR Capital Management, LLC December 2002 Abstract: The "Fed Model" has become a very popular yardstick for judging whether the U.S. stock market is fairly valued. The Fed Model compares the stock market's earnings yield (E/P) to the yield on long-term government bonds. In contrast, traditional methods evaluate the stock market purely on its own without regard to the level of interest rates. My goal is to examine the theoretical soundness, and empirical power for forecasting stock returns, of both the "Fed Model" and the "Traditional Model". The logic most often cited in support of the Fed Model is that stocks should yield less and cost more when bond yields are low, as stocks and bonds are competing assets. Unfortunately, this reasoning compares a real number to a nominal number, ignoring the fact that over the long-term companies' nominal earnings should, and generally do, move in tandem with inflation. In other words, while it is a very popular metric, there are serious theoretical flaws in the Fed Model. Empirical results support this conclusion. The crucible for testing a valuation indicator is how well it forecasts long-term returns, and the Fed Model fails this test, while the Traditional Model has strong forecasting power. Long-term expected real stock returns are low when starting P/Es are high and vice versa, regardless of starting nominal interest rates.
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Economic Letter2004-30; October 29, 2004Inflation-Induced Valuation Errors in the Stock MarketA recent front-page article in the Wall Street Journal documented anincreasing tendency among economists to move away from theories ofefficient stock market valuation in favor of "behavioral" models thatemphasize the role of irrational investors (see Hilsenrath 2004). Thelong-run rate of return on stocks is ultimately determined by thestream of corporate earnings distributions (cash flows) that accrue toshareholders. In assigning prices to stocks, efficient valuation theorysays that rational investors should discount real cash flows using realinterest rates or discount nominal cash flows using nominal interestrates. Twenty-five years ago, Modigliani and Cohn (1979) put forth thehypothesis that investors may irrationally discount real cash flowsusing nominal interest rates-a behavioral trait that would lead toinflation-induced valuation errors. This Economic Letter examines somerecent research that finds support for the Modigliani-Cohn hypothesis.In particular, studies show that the Standard & Poor's (S&P) 500 stockindex tends to be undervalued during periods of high expected inflation(such as the late 1970s and early 1980s) and overvalued during periodsof low expected inflation (such as the late 1990s and early 2000s).This result implies that the long bull market that began in 1982 can bepartially attributed to the stock market's shift from a state ofundervaluation to one of overvaluation. Going forward, the return onstocks could be influenced by a shift in the opposite direction.
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illusion in the stock market: The Modigliani-Cohn hypothesisRandolph B. Cohen, Christopher Polk, and Tuomo VuolteenahoABSTRACT: Modigliani and Cohn [1979] hypothesize that the stock marketsuffers from money illusion, discounting real cash flows at nominaldiscount rates. While previous research has focused on the pricing ofthe aggregate stock market relative to Treasury bills, themoney-illusion hypothesis also has implications for the pricing ofrisky stocks relative to safe stocks. Simultaneously examining thepricing of Treasury bills, safe stocks, and risky stocks allows us todistinguish money illusion from any change in the attitudes ofinvestors towards risk. Our empirical results support the hypothesisthat the stock market suffers from money illusion.
As always, you've come up with some interesting references. These are close to Graham's point, but none of these use high-quality corporate bonds as the object of comparison to the stock market. Keep in mind, I am not advocating Graham's methodology here. Even Graham did not have faith in his ability to time the market and he advocated that even defensive investors should never have less than 25% or their portfolio in equities, no matter what the market was doing. I was merely pointing out that Graham was being misrepresented in this thread.
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