- Interest rates and earnings yield were historically correlated.
- Is there a positive case scenario where reversion happens?
The S&P 500 earnings yield is merely the market weighted average earnings per share for the most recent 12-month period of all of the companies in the S&P 500 divided by the current market price of the S&P 500 index. You can look at normalized earnings/operating earnings or earnings as reported. As you can see in the chart, historically, earnings yield closely tracked the yield on the 10-year US Treasury. You will notice the fairly large diversion that occurred during the time of the Great Recession of 2008/2009. This anomaly has not reverted back. The main reason for this anomaly is because the 10-year US Treasury has not been floating freely. The Federal Reserve Bank has manipulated the money supply and interest rates for the last 10 years in a way that has not been seen before. This is true of most of the developed central banks in the world. There is no guarantee that the measurements outlined on this chart will ever converge, but logic dictates that it will. Earnings yield was at its highest point relative to the 10-year US Treasury yield when stock prices cratered during the bear market of 2008/2009. This is true because stock prices fell much further than actual earnings. In addition, when bond yields drop, investors will look to stocks to gain yield. One factor of calculating a stock’s value involves discounting the company’s future cash flows based on the current yield of the 10-year US Treasury and a risk premium. All things being constant, as the yield drops, the value of stocks goes up. This partially explains the powerful run up in stock prices. It is our opinion that the earnings yield and the Treasury yields will converge. There are a few ways for this to happen:
- Interest rates may increase at a time when corporations have become more leveraged. As higher interest rates eat into corporate profits, earnings may come down. This will lower the earnings yield while the Treasury yield is increasing. This scenario depends on stock prices remaining flat.
- Both profits and stock prices drop while interest rates are going up, however interest rates go up faster than the decrease in stock prices/increase in earnings yield.
- Stock prices increase faster than interest rates and the two measurements start to converge.
We find it unlikely that interest rates will continue to stay as low as they are as we have a strong consumer in the US and historically low unemployment. These things tend to increase inflation and increased inflation leads to higher interest rates. We feel that as rates rise, stocks will lose some of their value for the opposite reasons that we mentioned that increased their value. A concern of ours is that when the normalization of the earnings yield versus the Treasury yield happens, it will be preceded by an adjustment in stock prices that causes a spike in earnings yield while interest rates are rising. After this adjustment, we would expect normalization. This scenario causes us to be more conservative in our outlook for stocks and to own short maturity bonds as interest rates rise.
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