Earnings yields suggest investors are too pessimistic, equities are cheap
US companies’ average earnings yield, a measure of how much earnings shareholders get for their money, is currently 1.9 times 10-year Treasury yields, a ratio rarely seen since the 1950s. This is at least partly a function of historically low bond yields. However, the current ratio suggests investors are pricing in an even worse scenario for US earnings than that experienced by Japan during its ‘lost decade’ of deflation.
The widely used US Federal Reserve (Fed) model for evaluating whether stocks are cheap relative to bonds compares US 10-year Treasury yields to the S&P 500 earnings yield, or earnings per share divided by the share price. This ratio of earnings yield to bond yield, which is at levels not seen since 1958, suggests that equities are currently extremely cheap. One problem of using the Fed model is that it assumes all earnings are paid out to shareholders in the form of dividends, rarely the case, whereas a bond’s yield to maturity is what is actually paid. The current ‘payout ratio’ for US equities is 33% and therefore the equivalent delivered yield is far less than bonds. The average payout ratio since the 1960s is 53%, and we therefore expect a recovery in dividends given the recovery in corporate profits. Despite the Fed model making equities look exceptionally cheap relative to their long-term averages, using this model alone is not enough to value equities.
According to Shiller data shown in the chart opposite, earnings yields have been typically below bond yields since the late 1970s, when bond yields reached a peak and after which they have been in a long-term decline. The current ratio of earnings to bond yields is well above the post-World War II average of 0.9, while it has only moved above one during the mid-to-late 1970s and in 2003. For months when the yield spread was above one, average 12-month forward returns for the S&P 500 were 10.9%, compared to average returns of 5.9% during the overall post-war period. With the ratio currently well above 1, this suggests potential for above-average equity returns if this historic trend holds.
Earnings yields, as a function of price, can be seen as a reflection of earnings expectations. In other words, the current high level of earnings yield suggests that investors expect earnings to fall, if we assume that the ratio returns to the post-war average of 0.9. Our calculations suggest that a 50% decline in earnings is being priced in. This is much too pessimistic, even according to the most bearish forecasts, and suggests equity prices will rise to push the ratio back towards its longer-term average level.
However, there is a big question mark hanging over the assumption that we return to the post-1950s ratio of 0.9. Monetary policy is now so inflexible as a consequence of ultra-low interest rates that it could be argued that a return to the pre-1960s era of earnings yields consistently being above Treasury yields is more realistic.
Japan is an example of a more bearish view, where earnings yields averaged 1.6 over the past 20 years as the country struggled with deflation. But even if the US were to suffer a similar fate over the next 20-years, US equities would still look relatively cheap on this basis, given a ratio of 1.9. A repeat of Japan’s experience is not expected, given the much more aggressive efforts by US policy-makers to counter deflationary forces.
Whichever way you slice it, the current earnings yield suggest a significant further decline in longer term US corporate profits, something we don’t expect and which is not reflected in consensus estimates. With equity markets pricing in a situation worse than Japan’s lost decade, this particular hurdle is set very low for equities to make positive returns over the next 12 months.
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