By Palash R. Ghosh: Subscribe to Palash's RSS feed
October 1, 2010 5:42 PM EDT
The earnings yield (EY) on the S&P 500 index is now above 7 percent, which is typically the kind of yield an investors would get from an average junk bond.
EY amounted to 7.09 percent for the S&P 500 as of June 30, 2010 -- the highest quarter-end level in two decades.
This either means that stocks are very cheap (relative to bonds) and might make an attractive buy; or that investors have such a pessimistic view of the economy that they expect earnings growth to slow down over the next few quarters (or even years), given the grim economic backdrop.
EY is simply the earnings per share for the recent 12-month period divided by the current market price per share.
Generally speaking, if the EY of a broad stock index is less than the rate of the 10-year Treasury yield, stocks could be considered overvalued. If the earnings yield is higher, stocks might be considered undervalued relative to bonds
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Traditionally, stock investors have demanded an extra risk premium of several percentage points above the risk-free rates of Treasuries to compensate for the greater risk inherent in owning equities.
In a recent from Bank of America-Merrill Lynch (BoAML) noted that the decline in 10-year Treasury yields on expectations of higher risk of recession and higher chance of a second round of quantitative easing by the Federal Reserve – in tandem with relatively unchanged corporate spreads, has brought investment-grade bond yields to record lows and high-yield (junk) bond yields to pre-credit crisis lows of 2007.
As a result, the S&P 500 is offering an earnings yield as high as the junk bond index yield.
However, comparing stock yields with bond yields can be tricky.
BoAML explains, for example, that inflation expectations are embedded in bond yields but not earnings yields as earnings should rise over the long-term with inflation.
In addition, bond yields are usually higher than earnings yields as the inflation compensation included in bond yields is higher than the incremental risk premium of stocks versus bonds.
“A decline in inflation expectations can lower bond yields and can tighten the bond yield and earnings yield spread,” the report stated.
In any case, the S&P 500 having an earnings yield as high as a junk bond index yield seems rather odd if one assumes junk bonds are in general riskier than stocks.
“Only a shift in long-term inflation expectations from inflation to significant deflation can explain junk bond index yields equal to the S&P earnings yield,” BoAML said. “If one were to assume a long-term future inflation rate of 0 percent, then the current offered real yield on junk bonds and S&P stocks is both 8 percent.”
BoAML further notes that the current extremely high S&P 500 earnings yield suggests that stocks are priced for an earnings decline, “which we believe is unlikely without a US recession. Tight investment-grade and junk corporate bond spreads don’t suggest high risk of a recession. Thus, we believe stocks look very attractive versus bonds.”
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