Monday, August 16, 2010

More on Equity Earnings Yield

EconomPic has detailed the (what appears to be) relative attractiveness of the earnings yield of the S&P 500 on multiple occasions the past few months (here, here, and here are a few examples). Below we make another comparison... the earnings yield of the S&P 500 (in this case using Shiller's cyclical adjusted earnings) to the BBB corporate bond yield going back 35 years.

What the chart below shows is that the yield of S&P 500 has now surpassed that of the BBB rated corporate bond market (i.e. the lowest rated investment grade bonds) for the first time since the early 1980's.

Bull Scenario

Forecasts are for earnings to continue to grow.

Bear Scenario

Forecasts are just forecasts; a likely scenario is that forecasts are too rosy and earnings will reverse course (though this was accounted for in part within the first chart through the use of the CAPE [cyclically adjusted earnings], which uses a 10 year average of earnings). But it is possible that earnings over this entire 10 year period have been amplified by leverage, low interest rates, and a lack of reinvestment as production was pushed offshore. John Hussman (hat tip Credit Writedowns) provided the background for this a month back:

Current forward operating earnings estimates assume profit margins for the S&P 500 companies that are nearly 50% above their long-term historical norms. While we did observe such profit margins for a brief shining moment in 2007, profit margins are extraordinarily cyclical. Investors will walk themselves over a cliff if they price stocks as if profit margins, going forward, will be dramatically and sustainably higher than U.S. companies achieved in all of market history.
And this all may just prove that BBB corporate bonds are simply rich. According the Barclays Capital BBB corporate index, BBB corporate bond yield are just 4.4%... an all-time (since the index was tracked in 1988) low.

Source: S&P / Irrational Exuberance