Is the S&P's Earnings Yield Saying Buy?

Dec. 3.10 | About: SPDR S&P (SPY)

All of my market analysis starts with charts, but I like to confirm the message of a chart with various valuation metrics.

Specific to the S&P 500, one such metric is the index’s earnings yield. This is the inverse of the more well-known earnings multiple, and it measures an investor’s share of the composite of earnings expressed as a percentage.

In being expressed as a percentage, it can be compared to the yield offered by other investment options and most notably fixed-income securities.

The math is simple in the fact that it’s the earnings estimate, or actual since often 12-month trailing is used for this metric, divided by the S&P’s value at any given time too. This works equally well in evaluating individual equities.

Considering we’re nearly at the end of 2010, I’m using a rounded consensus earnings estimate on the index of $81 and this provides us with an earnings yield off of Wednesday’s close of 6.6%.

With the 10-year Treasury yield at 3% and narrow spreads across the spectrum of investment grade paper, the S&P’s earnings yield makes the bond market look expensive.

In comparison, stocks look cheap judging by the S&P’s earnings yield of 6.6%.

Interestingly but not always useful, the Fed Model, but not sanctioned by the Federal Reserve, claims that the S&P is in equilibrium when the index’s earnings yield matches the yield on the 10-year Treasury. Clearly, there’s a pretty wide discrepancy right now and this may suggest that bonds are likely to decline in value while stocks will gain if the Fed Model is taken into account.

I say this because if I try to create such an equilibrium today with the 10-year at 3%, it suggests that the S&P should be trading at 2,700. While anything is possible, the S&P at 2,700 today or even in 12 months seems absurd on an estimate for $81 in earnings or next year’s rough estimate of $88 not to mention an incomprehensible chart.

The other possibility is to keep the S&P fixed at 1,221 and this suggests that the 10-year should be at the aforementioned 6.6%. Now while that seems somehow less absurd than S&P 2,700, it seems unlikely in the next 12 months even with my view that Treasurys will spike higher and higher than 6.6% at some point down the road.

Rather, if we’re to give credence to the Fed Model, I think we may be looking at a scenario similar to what I suggest above or the idea that bonds are likely to decline as interest rates rise simultaneous to a rise in the stock market even though this is not the typical scenario.

In turn, an earnings yield of 6.6% on the S&P 500 may mean that there’s still room to go long equities even with the seemingly absurd 80% move up by the index since March 2009.

It would seem, too, that this metric confirms the message of the S&P’s chart for its technical aspects point to the idea that there’s room for the index to move higher.

Specifically, the likely continuation of the cyclical bull market that began in March 2009 is supported by the positively-inclined Fan Principle and a confirmed Inverse Head and Shoulders while perhaps being “pulled” higher by the magnet-like area of resistance/support found around 1,300.

It is this picture of the S&P, shown with the trendlines at that appears to be consistent with the “Buy” signal that the index’s current earnings yield of 6.6% seems to be sending.

Disclosure: Long BGU, SAA, FAS