Recently, I published an article that put the current low price to trailing earnings ratio of the S&P 500 Index (SPY) in a historical context, and illustrated that earnings multiples at these current low levels have portended outsized forward returns over the next year. The current article examines the earnings yield of the S&P 500 Index (trailing twelve month earnings divided by current price level), its relative spread over a historical index of corporate bond yields, and potential implications for the broad equity market in 2012.
Below is a graph of the S&P 500 Index versus the trailing twelve month earnings. It illustrates that the market is currently priced historically low relative to trailing earnings. Since the market is forward looking, this signals that the market is either inexpensive, or that market participants expect forward earnings to fall rather dramatically. With earnings needing to fall by roughly a quarter to revert to their historical average, it appears that there is cushion built into the current price level despite the macroeconomic global headwinds brought on by over-leverage of many developed economies.
The next graph shows the earnings yield over time. At the end of 2011, the earnings yield of 7.56% placed the current earnings yield in the 75th percentile versus its historic range. While not overly attractive on a historical basis, it is still meaningfully higher than the trough earnings yield of 3.31% in June 1999 as the tech boom excess moved the market well higher than its earnings capacity at the time. Considering that the price level on the S&P 500 is still lower than the closing level of 1373 at the end of June 1999, this low earnings yield pointed to a market overvaluation.
On a standalone basis, the earnings yield is not a perfect barometer however. The peak earnings yield of 14.37% occurred in April 1980 when the ten-year Treasury stood at 10.76%, long Baa-rated bonds yielded 14.19%, and inflation as measured by the consumer price index stood at 14.7%. In real terms, the actual earnings yield was close to zero despite the high nominal print.
Many market pundits have compared the earnings yield relative to the 10-yr Treasury yield. This relative basis is an improvement over an absolute examination since the Treasury yield should have the market's inflation expectations embedded into its pricing. A better examination of the earnings yield would be relative to where the market could finance its debt, including the market credit spread in addition to the Treasury yield. A high spread between earnings yield and financing yield would indicate that companies are able to obtain relatively inexpensive financing for their profitable projects.
Below is a relative graph of earnings yield less the yield on long Baa-rated corporate bonds. The Federal Reserve Bank of Saint Louis publishes this data in conjunction with Moody's with historical data back to 1919. While the yield on Baa-rated bonds is now close to a fifty-year low, the earnings yield has been rising. The relative difference between the two yields is now at a more than a thirty year high. When the difference between earnings yields and corporate bond yields was last above 200bp (October 1979), the market had a price return of over 25% over the next twelve months. When this differential hit its all-time peak (February 1958), the market rallied 36% over the next year.
The high earnings yield relative to financing yield means that companies can finance organic value-added projects at a historically profitable spread. We should also see accretive acquisitions by companies who can utilize cheap financing in the public debt markets to purchase smaller, profitable businesses. If companies fail to see new profitable projects, or are unable to make sensible acquisitions in this low growth environment, they can also finance the repurchase of their own companies through debt-financed share repurchases.
Walt Disney (DIS) placed 5 and 10-year bonds on February 9th at 1.125% and 2.55% respectively. With the sizing of the deal tilted more towards the 5-year tranche, the weighted average interest expense was a paltry 1.53%. If Disney chose to repurchase shares with the bond proceeds, savings from the dividends on those repurchased shares (1.44% yield) and savings on taxes due to the deductibility of corporate interest expense would actually exceed what is paid on the bond coupon payments. AT&T's (T) bond deal on February 8th is another example of corporate re-leveraging that could actually boost earnings per share if used for share repurchases. The company borrowed $1 billion at 3% for ten years, $1 billion at 1.6% for five years, and $1 billion at 0.875% for three years. This 1.825% average yield pales in comparison to AT&T's 5.77% dividend yield. With AT&T's thirty-year debt trading around 4.7%, the company could raise semi-permanent capital where the principal is not repaid for a generation at less than the cash it sends annually to its shareholders. Kimberly Clark (KMB) issued $300 million of ten year notes on February 6th at 2.4%, or 150 basis points lower than the company's 3.9% dividend yield. McDonald's (MCD) re-opened a September 2011 bond issue and added on $750 million of ten year notes on February 2nd at 52 basis points over the ten year Treasury for a yield of 2.34%, a 46 basis point discount to its 2.8% indicated dividend yield. One day earlier IBM issued $1 billion of a five year bond issue at 1.25% and $1.5 billion of a three year issue at 0.55%, well below the 1.55% dividend yield on the stock. That same day, Proctor and Gamble (PG) achieved the lowest ten year bond coupon on record when it borrowed $1 billion at 2.3% (dividend yield 3.28%).
While macroeconomic risk will remain in the headlines and we will undoubtedly see pockets of volatility, the gap between earnings yield and financing yields of major U.S. corporations should buoy the domestic stock market at a minimum and potentially send it to quite solid gains. According to Bloomberg's Financial Analysis function, Net debt to EBITDA of the constituents of the S&P 500 is currently less than half of the level it was at the end of 2007.
While some of this difference is a function of the shift in the constituency of this capitalization weighted index, balance sheets of U.S. companies are in general now much healthier, possessing more liquidity and less debt than pre-crisis. Given the high earnings yields we are seeing at these corporations, expect some of them to re-leverage, adding incremental debt to repurchase equity. While I am not advising following Larry Fink of Blackrock into 100% equities, I would certainly much rather own the earnings streams of U.S. corporations than provide the future leverage.