In a recent article, Felix Salmon raised an inquiry as to why the spread between the S&P 500 earnings yield and the 10Y Treasury Bond yield - which he cited at 700 basis points - is at such unprecedented heights. Although he provided no definitive answers, he referred to the spike in the "earnings yield spread" as "the great divergence" and implied that it was potentially a market event of great significance.
It is good that Salmon has brought this issue to the fore, because I believe that for financial market participants, correctly divining the causes of this observed "great divergence" may be the single most important determinant of the investment performance of stocks and bonds in the next few years.
In this article I will first review the theory and empirics that underlie the importance of the earnings yield spread, relating this indicator to the better-known "Fed Model." I will then briefly outline some potential interpretations that could explain the "great divergence" of the earnings yield spread as well as the potential significance of these various scenarios for financial markets.
What Is the Earnings Yield Spread?
The earnings yield expresses a relationship between the earnings per share of a stock and its price - except that instead of expressing this relationship as a "multiple," (as in the PE ratio) it is expressed as a percentage "yield" in order to make it comparable to the yield on a bond. For example, for the S&P 500 as a whole the earnings yield is derived by 12-month forward EPS by the price of the stock. This figure is equivalent to the reciprocal of the 12-month forward PE of the S&P 500 index.
The earnings yield spread is defined as the difference between the earnings yield of a stock (or index of stocks) and the yield on the 10Y Treasury Bond. This indicator measures the difference between the rate of return required by holders of stocks and the rate of return demanded by holders of 10Y U.S. Treasury bonds (considered the "risk free rate").
Just as occurs with bonds, the yield on stocks has an inverse relationship to its price: Assuming all else remains equal, as the earnings yield rises the price of the stock becomes cheaper.
The earnings yield, the 10Y Treasury Bond yield and the earnings yield spread are simultaneously illustrated here in this graph provided by Salmon which covers the period ranging from 1985 to the present:
Please note that from the early 1980s through the early 2000s, the earnings yield spread very consistently mean-reverted around the 0% level.
The Earnings Yield Spread and the Fed Model
The observed empirical relationship between bond yields and earnings yields in the 1980s and 1990s helped give rise to the so-called "Fed Model." The so-called Fed model was not invented by the Fed. However, the model was popularized in the late 1990s due to reports that the Fed was using the model in order to gauge the valuation of stocks.
The Fed Model expresses the relationship between the 10Y Treasury Bond yield and the 12-month forward earnings yield as a ratio as opposed to a spread. However, note that the earnings yield ratio and the earnings yield spread are essentially the exact same thing.
According to the "Fed Model," when the earnings yield ratio reached a certain level above or below zero, stocks are considered to be overvalued or undervalued. The graph of the earnings yield spread provided by Salmon expresses the exact same relationship, except that it is expressed in terms of a spread rather than a ratio.
The Theoretical and Empirical Underpinning of the Fed Model
No matter whether one ultimately agrees with it, it must be admitted that the simplicity of the Fed Model (and the earnings yield spread model) has much to recommend it both theoretically and empirically. Consider:
- The Fed Model finds strong theoretical support in the fact that in a growth perpetuity calculation of the intrinsic valuation of the S&P 500, the earnings yield on stocks will equal the risk free rate (in this case the yield on the 10Y Treasury Bond) if the long-term growth rate of earnings is equal to the equity risk premium. In other words, if the equity risk premium is the same as the expected growth rate of earnings in perpetuity then the earnings yield of stocks should equal the yield on the 10Year Treasury Bond. Theoretically, this simple hypothesis is unassailable. Does empirical observation support the theory? Consider below:
- Since 1870, the inflation rate in the US has been roughly 2.1%, a rate consistent with modern Fed inflation targeting. The real rate of return on Treasury Bonds during this period averaged roughly 2.6%. This equates to a nominal yield of 4.7% on 10Y Treasury Bonds.
- Theoretically, it has been argued that in the long term, long term nominal bond yields should equal nominal GDP growth. This hypothesis is well supported by long-term historical evidence: In the U.S., nominal bond yields on 10Y Treasury bonds and nominal GDP growth rates have demonstrated a strong tendency to converge.
- The long-term sustainable rate of nominal GDP growth for the U.S. economy is usually forecasted in the range of 4.5%-5.0% (2.1% inflation +2.4%-2.9% real GDP growth). This range is supported both by economic theory and the long-term historical record.
- It is assumed that the long-term rate of earnings growth (in perpetuity) for the S&P 500 will be equal to the long-term rate of nominal GDP growth. Not only is such an assumption theoretically sound, the long-term historical record supports it.
- The equity risk premium is typically cited as being in the range of 4.5%-5.0%. This range is strongly supported by theory and is strongly supported by the long run excess returns of stocks versus bonds.
These basic historical facts permit the stylized assumption at the heart of the Fed Model that the equity risk premium equals (or cancels out) the growth rate of earnings in perpetuity.
Given these assumptions, the fair value for the S&P 500 occurs when the earnings yield on the S&P 500 equals the yield on the 10Y Treasury bond.
And indeed, from about 1980 through the early 2000s the earnings yield spread tended to mean revert around the 0% level, providing strong empirical support for the theory.
The "Great Divergence"
At the time of Salmon's cited article the consensus 12 month forward PE on the S&P 500 was around 11.7X (based on operating earnings). This translates to an earnings yield of approximately 8.5% (1/11.7). At the same time, the 10Y Treasury Bond yield was roughly 2.25%. Thus, the earnings yield spread was roughly 6.25%, or 625 basis points.
Note that according to the graph provided by Salmon, the earnings yield spread has historically only reached such heights during the peak of the 2008-2009 panic. Note that in the graph provided by Salmon, which goes back to 1985, the earnings yield spread diverged significantly from its long term mean in the mid 2000s and has not looked back, spiking violently in 2008-2009 and most recently in August of 2011.
The "great divergence," as Salmon described it, is of great potential significance to investors because it may indicate either one of two things:
- One possibility is that stocks and /or bonds are being priced inefficiently. This would suggest opportunities for investors to earn abnormal returns.
- The other possibility is that the "great divergence" in in the earnings yield ratio is signaling some "great divergence" or major change in the economic and financial futures of the United States. Specifically, according to this interpretation, the future looks very bleak.
Possible Interpretations of the "Great Divergence"
Below, I will briefly summarize possible explanations for the "great divergence." In a follow-up article, I will discuss these possible scenarios in greater detail. For now, here is the summary of the scenarios grouped into two broad hypotheses:
The Mispricing Hypothesis
This hypothesis contends that stocks and/or bonds grossly mispriced due to fear and panic amongst market participants. According to this view, the mispricing creates opportunities for investors to reap abnormal profits. There are three variations of this view:
- Treasury Bonds are extremely overvalued.
- Stocks are extremely undervalued.
- All of the above.
The Doomsday Hypothesis
This hypothesis contends that the upward spike in earnings yields spreads is correctly anticipating/discounting future fundamental changes in the U.S. economy and financial markets. According to this view, the future will be fundamentally different from the past, and it won't be pretty. There are various potential arguments in support of this view:
- Long-term GDP and EPS growth will be lower than in the past.
- Long-term profit margins will contract, and with it returns on capital invested.
- The long-term equity risk premium will rise.
- 10Y Bond yields will no longer be considered to be a "risk-free rate." 10Y yields will embed a significant risk premium to compensate for the risk of default and/or inflation associated with holding these bonds.
- The real rate of return on bonds WILL decrease.
- Back to the future. The future that awaits US investors will look more like the past - in particular, prior to 1960. Macroeconomic and financial conditions will become considerably more volatile, will entail more costs and will result in lower profitability.
The "great divergence" in the equity yield ratio is of potentially profound significance to investors. Indeed, understanding this issue and divining it correctly will likely be the single most important driver to investment performance in the next few years.
The investment implications of either the "mispricing hypothesis" or the "doomsday hypothesis" are as diametrically opposite as they are profound.
Those that believe the former hypothesis will aggressively purchase stocks and/or aggressively sell bonds. By contrast, to the extent that the latter hypothesis proves more prescient, economic and financial conditions will deteriorate immensely in the next several years and owners of stocks may suffer devastating losses while short-sellers of bonds could incur similar drawdowns.
In a follow up article, I will discuss a number of different scenarios and possibilities in greater detail so as to correctly frame the discussion.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.