Today, a government bond pays a 3% yield but inflation is running at 3.5% so this is a losing proposition. You can do better with a corporate bond at 5% but you are locked-in for 5 years. Of course, a savings account doesn’t do you any good at such low rates plus the taxes. Gold just broke below its 200-day moving average. Is it really a terrible world out there? So where does that leave stocks in the market mix? To compare the best place to allocate capital, you must use the earnings yield.
Simply, money moves to where it is treated best. You see this frequently in the foreign exchange market with the carry trade as money moves to the highest, stable interest rate. It is very similar in the financial markets. The way to determine where money will be treated best is using the earnings yield to compare different assets. The earnings yield is used by many investment managers to determine optimal asset allocations
Money managers often compare the earnings yield of a broad market index (such as the S&P 500) to prevailing interest rates, such as the current 10-year Treasury yield. If the earnings yield is less than the rate of the 10-year Treasury yield, stocks as a whole may be considered overvalued. If the earnings yield is higher, stocks may be considered undervalued relative to bonds. Economic theory suggests that investors in equities should demand an extra risk premium of several percentage points above prevailing risk-free rates (such as T-bills) in their earnings yield to compensate them for the higher risk of owning stocks over bonds and other asset classes.
Here is what the earnings yield looks like today with different asset classes:
· Savings account – 0%
· Government bonds – 3%
· Corporate Bonds – 5%
· S&P 500 – 7.7%
Based on this list, the S&P has the highest earnings yield and has a built in margin for risk above bonds. Then, with the S&P 500 you also have an opportunity for price appreciation and dividends, making stocks even more attractive. The yield difference between stocks and bonds is at an extreme reading today. Eventually, this spread must change with either bonds crashing or stocks making a big rally. In my opinion, stocks are undervalued and we will see a significant rally to correct the earnings yield (meaning stocks will accelerate their PE ratios through price appreciation). To get back the yield relationship back in line, the S&P 500 PE ratio will need to move from its current 12.98 to around 20 resulting in an earnings yield of 5%. This will be the next great bull market like 1980. When will it start, no one really knows the market timing with the global news changing each day.
The long-term investor should consider how to reallocate their capital to be prepared for this stock rally. The way I do this is to look at the earnings yield of different market sectors to determine where stocks are most undervalued. In the table below, I have listed ETFs in each major market sector to determine the PE ratios of the stocks held in the ETF. Then, I ranked the ETFs by their earnings yield with the highest at the top of the list. This is your starting point to look for the most undervalued market sectors.
This process results in four ETFs having an earnings yield higher than the S&P 500: Aerospace & Defense (PPA) at 8.61%; Basic Materials (IYM) at 8.35%; Financials (IYF) at 8.32%; and Pharmaceuticals (PPH) at 7.80%. In comparison, utilities were one of the best performing sectors in 2011 with a 15% return. The price appreciation as measured through its PE has lowered its earnings yield making this sector more expensive than the four sectors mentioned. Big pharmaceutical companies were extremely cheap in early 2011 as they have been range bound for a period because of the impending health care reform. Now, investors have started allocating more capital to this sector as the PPH has a return of 10% in the past year. However, the pharmaceutical sector is still undervalued along with the aerospace & defense, basic materials and financial sectors.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.