The S&P 500 Valuation Tool That Shows 2007 Peak a Long Way Awayby
Earnings yield vs bond yields still flashing bullish signals
The gap is part of the dividend case on American equities
A year of profit stagnation has left the S&P 500 Index’s price-earnings ratio flirting with some of its its highest readings since the Internet bubble. Judged against bonds, though, stocks remain stubbornly cheap.
Plotting the index’s per-share earnings against the yield on the 10-year Treasury note, a technique sometimes referred to as the Fed Model, shows the S&P 500 is still less expensive than any time during the 2002 to 2007 bull market. Stock valuations are held down in the comparison by some of the lowest bond payouts ever.
The stock market’s still-healthy earnings yield underpins a number of bull cases, including ones based on dividends that are funded by corporate profits. The average payout by S&P 500 companies is 2.18 percent, about 0.5 percentage point higher than the 10-year yield and a wider gap than 94 percent of the time since 2002.
“It puts a floor beneath the market to some degree,” Marshall Front, chief investment officer at Front Barnett Associates LLC in Chicago, said. “It’s a relative analysis that provides you with a perspective on how equities are priced relative to a risk-free rate, and if investors expect a reacceleration of earnings, then it could presage a significant move in the equity market.”
The model is far from universally beloved on Wall Street. Critics such as AQR Capital Management LLC founder Clifford Asness have contended the technique doesn’t work because inflation affects stock valuations and interest rates differently.
To investors like Goodhaven Capital Management LLC’s Larry Pitkowsky, comparisons between earnings and Treasury yields don’t hold as much water as they once did. The Federal Reserve’s quantitative easing program and sustained period of near-zero interest rates pushed bond yields artificially low, he said, skewing the difference between the two.
“The real question here is with Treasury yields. With the 10-year at this level, stocks would have to trade at something around 50 times earnings for this metric to say stocks are topping,” Yousef Abbasi, global market strategist at JonesTrading Institutional Services LLC in New York, said. Still, he said, “it has been and continues to be one of the support pillars for equities.”
Swings in stocks have gotten wider in the past two weeks as a 15 percent rebound in the S&P 500 that began in mid-February lost steam. Rallying equities haven’t been enough to faze the bond market, where the yield on the 10-year Treasury has fallen 57 basis points to 1.7 percent from the start of the year.
With the fourth straight quarter of declining profits behind them, equity investors remain wary of U.S. stocks despite the S&P 500 nearing all-time highs. The benchmark index has inched up 0.1 percent on the year amid falling earnings, bringing the price of the gauge to as much as 19.5 times earnings, the highest since 2010.
The comparison between stock and bond yields offers a way to look at valuation metrics in terms of how much owners of each instrument can expect to get back in profits or interest payments on the money they invested.
Those that ascribe to the model see an advantage to owning the equity market, where the S&P 500 yields 5.2 percent in earnings. The gap to the Treasury yield, while narrower than at the start of the bull market, is almost seven times wider than its smallest point in 2007.
Part of the bull case derived from earnings yield is what it says about companies’ ability to maintain or grow dividends. A relatively high yield suggests investors seeking regular cash outlays may continue to be willing to buy stocks as a riskier, but more profitable, alternative to lower-yielding asset classes like bonds.
“The spread between the dividend yield and the 10-year Treasury is in some ways more important in today’s world,” Michael Purves, chief global strategist at Weeden & Co LP in Greenwich, Connecticut, said by phone. “During risk-off periods, investors can consider the dividend yield relative to the 10-year yield, which provides a lot of buffer for downside protection.”