Here is a link to something I wrote on my blog about some study I did a few years ago on the SPX based on figures Robert Shiller posts on his Yale Univ website. I spent a lot of time on this. http://mannfm11.blogspot.com/
Next, here is a link to John Hussmans site. He is the manager of the Hussman Funds. He blows holes in this undervaluation theory. But he has a lot higher valuation than I do. http://www.hussmanfunds.com/wmc/wmc100712.htm
These guys use treasuries to value stocks. Stocks aren't treasuries. Ask the people who owned Enron, Worldcom, Bear Stearns, Lehman Brothers, General Motors (who would have thought that ever went broke?), Fannie Mae, Freddie Mac, Citigroup and quite a few more tha were multi billion companies? I recall MCI was one of the top 5 market caps on the Nasdaq, yet at an even larger cap, merged with Worldcom, it went broke overnight. Enron was a huge company. Citicorp has had its share value diluted massively and trades at under $5 a share. I think the current ownership consists of 20% of the former ownership. It would be zero if not for a bailout. MSFT sells at $24. It was $60 on the top and there were more shares then. CSCO is worth less than $150 billion. It was worth $600 billion on the top. GE would have gone to zero without the government guaranteeing their paper. INTC or Intel was worth over $600 billion on the top. Worth $102 billion now. Those 4 companies were all worth at least $600 billion each. All of them have spent a fortune buying back stock. Whose stock? John Chambers stock at CSCO, Bill Gates stock at MSFT, who knows whose stock at GE and whose at INTC. Those companies, worth a cumulative near $2.5 trillion on the top are now worth $102 Billion plus $155 billion (GE), $208 billion (MSFT) and $120 billion (CSCO) for a total of $585 billion. Total loss from the top? Nearly $2 trillion. Some of their earnings have held up. Adding the 4 together, you won't get a 2% yield.
The formula for valuing stocks is the discounted value of its dividends expected over time. The idea you value stocks compared to treasury yields is flat nonsense. You value them against the risk free rate of return adjusted for growth. Risk free starts at 3%. Real growth of the market is maybe 1/2 to 1% if you get healthy inflation. The risk premium of stocks is about another 3%. History, prior to the bubble dilution was 3% inflation, 4.7% dividends and around 1% real growth over a measured 75 year period. This gave the imagined return of about 9%, which corresponds to a 6% risk free return at 3% inflation plus 3% risk premium. Remember AAA bonds yield more than governments and most corporations on the exchange aren't investment grade, but junk. Only a handful of companies have AAA ratings and I would venture half that do only have them because the government guaranteed them. Junk bonds are in the 10% range and they are less risky than the underlying stock, unless Obama is making the deal for the UAW.
That said, in order to fairly value the 10 year treasury, one has to realize there won''t be any measurable inflation over the next 10 years. But, the recipe for stock discount isn't the 10 year treasury, but a forever rreasury. Also, without inflation, there won't be any growth, real or nominal. So, to measure a return against a risk free measure during a time of credit crisis is insane. IF anything, the risk should be even higher, as it takes credit to keep cash flowing to corporations.
Lastly, take note of the difference between the SPX and the Dow. Note that Citi, Bank of America and JPM/Chase are all Dow stocks, as are Chevron/Texaco and Exxon/Mobil. Do you actually believe the earnings on the banks are real? Also, Wall street is running an oil corner, either as a front to keep the OPEC countries afloat or for their own profit and these oil company earnings are also inflated. This is why their stocks are trading at a lower price than when oil was $34 a barrel in late 2008. Most in the market know the earnings of these companies is a fraud. You might note that Citi is still trading at around $4 and BAC in the mid teens. Pull out this nonsense and the PE of the Dow goes to arouond 20.
I figure what the real sustainable earnings on stocks are by doubling hte dividend and dividing it into 1. The SPX is about 2% so the sustainable PE is 25. The values of the 4 companies I listed above are proof the shareholders derive little benefit out of continued stock repurchases.