Stock Investors Are Drunk on the BEER Ratio
It doesn’t seem possible that anything with the acronym BEER could be harmful to investors. But let’s just say they’ve gotten a wee bit tipsy on the current Bond Equity Earnings Yield Ratio. The ratio, known in Wall Street parlance as BEER, compares the current yield on 10-year Treasury bonds to the earnings yield of stocks. The earnings yield is the inverse of the price-earnings ratio. The theory is if stocks are yielding more than bonds -- a BEER ratio of less than one -- then stocks are cheap.
The current earnings yield on stocks is 5.21 percent, significantly less than its 7.47 percent historical average over the last 142 years. Treasury bond yields are so low at 2.15 percent, the BEER ratio of 0.41 makes stocks look cheap in comparison. The ratio has been getting a lot of buzz -- writers at CNBC ("This Bullish Indicator is at a 58-Year High"), the New York Times ("Based on Relative Yields, Stocks Look Cheap"), USA Today and the New York Federal Reserve Bank have cited it in analyses of whether the stock market has room to run.
Zero Predictive Value
Yet if you dig into the numbers, the ratio is worth less as a predictor than flat Budweiser. This March, the Leuthold Group, a Minneapolis-based financial research firm, published a report entitled “Valuing the Stock Market: Do Interest Rates Matter?” In it, author and Leuthold chief investment officer Doug Ramsey revealed that the BEER ratio had zero predictive value for stock performance when yields on Treasury bonds were below 6 percent from 1878 through March 2013.
Only at Treasury yields of 6 percent or higher do investors perceive Treasury bonds as real competition to stocks, Ramsey says. At that point they begin to compare the valuations of the two asset classes to determine which to own. Otherwise, investors view the asset classes separately and their relative valuations are meaningless to them.
Investors who drink the BEER ratio Kool-Aid could be in for some serious stumbles. “You can single out a number of points in history where the ratio looked extremely high or extremely low and was misleading as to what you should have been doing in the stock market,” Ramsey says. He points out that stocks had high BEER ratios indicating they were overvalued in August of 1982 and October 1990 -- two of the best times to buy stocks historically. Meanwhile, in February 2008, the ratio was well below 1, and stocks fell 50 percent in the next 12 months.
While there may be a performance correlation when bond yields are high, in one key respect the logic of ever comparing stocks to Treasuries seems seriously flawed. Treasuries are contractually guaranteed to pay back the principal, or par value, you invested in them when they mature. So if you buy a newly issued 10-year Treasury with $1,000 par value, in 10 years you will get your $1,000 back. That guarantee is backed by the full faith and credit of the U.S. government.
Stocks promise nothing. Unlike the interest on a bond, a stock’s earnings and dividends are unpredictable and its value is not contractually guaranteed. In fact, if you look at the prospectus of a stock it says that the par value is one penny. The only reason it says that is that in some states it’s illegal for a prospectus to say a stock is worth nothing.
Pundits use BEER to rationalize their irrational exuberance, Ramsey argues. “I have a very cynical view on this ratio,” he says. “It’s one of the last remaining measures that makes the stock market look cheap. People are doing what they can to make some weak valuation argument and this is what they come up with. I think it’s disingenuous.”
It turns out there’s a far simpler way to predict stock market returns. Leuthold’s research indicates that over the long term stocks’ returns tend to mirror their earnings yields. For this reason he expects stocks to deliver a 4 percent to 5 percent annualized return over the next decade.
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