The earnings yield for the S&P 500 is at its highest level since 1996. The fact that the S&P 500’s earnings yield is higher than the 10-year Treasury yield suggests that either stocks are undervalued or bonds are overvalued. We think it is the latter rather than the former and that the valuation gap in the chart below will likely be closed primarily by rising bond yields, though there is some potential for rising P/E multiples (the reciprocal of earnings yields).
Unless the economy is in recession, or emerging from recession, which temporarily depresses earnings yields (e.g. 7-90-2/91 and 3/01-11/01), investors should not expect earnings yields to fall below 5%, which equates to a 20x P/E multiple. [click to enlarge]