Wednesday, 4 July 2012

10-year Average Earnings- and Dividend Yields, S&P 500 (as of 03.07.2012)

Earnings- and dividend yields as of 03.07.2012

Based on the closing price of the S&P 500 index of 1,374.02 on 3 July 2012 and data from Professor Robert Shiller's home page, the current yields are as follows (please refer to the June 2012 analysis for explanations):

The current earnings yield of 4.64% is, as last month, higher than the historical average. It is lower than the 4.82% reported last month however as the S&P 500 composite has moved higher and as the 10 year average real earnings was up only fractionally (from $63.74 to $63.99). Although just marginally, the S&P remains cheaper than average since 1991 when based on earnings yield only.

The current dividend yield of 1.84% is identical to the longer term average so the market is currently valuing the index exactly in line with the longer term average. The dividend yield was down from the 1.93% reported last month. The current 10 year average real dividend of $25.38 was virtually unchanged from last month, so the drop in the yield on last month was due to the index moving higher.

The long interest rate (the 10 year US Treasury Constant Maturity Rate GS10) continues to decline, falling to 1.61% on 2 July 2012, the lowest ever reported (going back to 1950).

Subtracting the long interest from the earnings yield gives us the spread between the two series (see bottom of page for caveats of such a comparison).

The current spread of 3.03% (about the same as reported last month) and remains some of the highest ever reported since 1991 and more than 400 basis points higher than the average spread of negative 1.00%. As the S&P 500 is currently valued slightly lower than historically based on the earnings yield, the current spread indicates that the market values the long term US treasury much higher than earnings. Another possibility (of many) is that the market expects interest rates to increase in the future. Either way, for the long term investor (5 years +), the S&P 500 is currently undervalued compared to the 10 year US treasury based on historical relationships. Although long term rates are likely to remain low (and possibly go even lower) for some time as the Federal Reserve continues its Maturity Extension Program and Reinvestment Policy program through buying longer term treasury securities and selling shorter term securities, one day it will end these operations, presumably. And when that happens the longer term treasury securities will no longer have the current artificial support for keeping the rates low.  

Please note the following caveats/criticisms of models comparing earnings yield with treasury yields (as noted by Stimes and Wilcox in "Equity Market Valuation when discussing the "Fed Model"):

1. It ignores the equity risk premium
2. It ignores earnings growth opportunities
3. It compares an arguably real variable (the earnings yield) with a nominal value (the T-bond yield).

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