Serious Money Rory GillenValue may well be in the eye of the beholder in the world at large, but in the stock market value always has a benchmark.

One useful and easy-to-follow measure of value in equities is the "Fed Model".

It compares the value on offer from equities (shares) relative to government bonds and tracks that relationship over time.

Investors have a choice and are likely to move from one asset class to another, depending on which offers better value, while taking account of risk.

The following analysis concentrates on the comparison of US equities against US bonds.

What happens in the US capital markets usually reverberates across the other developed markets, so it should be representative of markets in general.

To examine the value on offer in equities, I will use the S&P 500 as a platform. This index represents 500 fairly large US companies and is widely used as the benchmark index against which a fund manager's performance is judged when investing in the US stock markets.

Current consensus forecasts suggest that the companies making up the S&P 500 are set to deliver $73 (€61) of earnings per share over the next 12 months.

The S&P 500 index is currently trading at just under 1,200, or 16.3 times expected earnings (1,200/73).

As a reference point, over the long-term, the S&P 500 has traded on an average of 14 times earnings. One can also express earnings relative to the price paid, which is known as the earnings yield.

Here, we simply switch the calculation around (73/1,200) and we can determine that earnings of $73 on a price of 1,200 represent an earnings yield of 6.1 per cent.

With US 10-year bonds currently yielding four per cent, one can see that US equities appear to offer a premium to US bonds at this time.

The accompanying chart highlights this "value" relationship between equities and bonds in the US back to 1980. The chart is derived by dividing the bond yield by the earnings yield so that when the chart is below "1", equities offer a premium and above "1", bonds offer a premium.

What is clear is that equities normally offer a premium, and for good reason, a risk. This premium disappeared in 1999 when the yield on offer from bonds was at a premium to equities.

This was a strong indication at that time that the risk of holding equities compared to bonds was unacceptably high. That, in itself, however, did not immediately halt the bull market in equities at that time.

Currently, the chart shows that the premium on offer is significant.

If it wasn't for the fact that the current forecast per earning rating of 16.3 on the S&P 500 is some 15 per cent ahead of the long-term average, one might be justified in concluding that equities currently offer better value than bonds.

But things are rarely that simple. Many market analysts believe that, with US short-term interest rates already over three per cent and likely to head near four per cent by the end of the year, a yield of four per cent on US 10-year bonds is dangerously low and in no way protects an investor from the huge imbalances in the US economy.

These imbalances include a collective savings ratio of near zero per cent, massive government borrowings and a mounting trade deficit, which all point to an economy that is overspending. Any rise in 10-year bond yields would erode the premium on offer in equities. Equally, corporate earnings in the US have recovered strongly in the past few years and are near a peak as a percentage of GDP.

So there is no guarantee that the $73 that the market expects to be earned on the S&P 500 over the next year will be repeated in subsequent years.

Any fall in earnings, through recession or otherwise, would similarly erode this apparent premium on offer in equities.

So what does an investor conclude? As always, opinion is divided. Some feel that earnings will fall and/or bond yields will rise, eroding the premium that equities are supposedly offering.

Others of a more bullish disposition claim that, with low inflation and a surplus of savings elsewhere in the world, bonds are fairly valued. This camp believes that the "Fed Model" is highlighting good value in equities relative to bonds.

So there are no definite conclusions, just probabilities. Nonetheless, from a private investor's viewpoint, the inset chart can be replicated with ease. It is a useful tool in at least understanding the debate over the relative value on offer in equities, compared to bonds at particular points in time.

The US 10-year bond yield and the level of the S&P 500 index can be obtained from the newspapers or on various websites. And the expected S&P 500 earnings can be obtained from any advisory stockbroking company or via the S&P website, http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS

Rory Gillen is formerly head of research in Merrion and now manages an equity fund on Merrion's behalf.