Thursday, 7 March 2013

Earnings Yield Improves Slightly, 10-year Average Earnings- and Dividend Yields, S&P 500 (as of 6 Mar-13)


Earnings - and dividend yields as of 6 March 2013
Based on the closing price of the S&P 500 index of 1,541.46 on 6 March 2013 and data from Professor Robert Shiller's home page, the current 10-year earnings- and dividend yields for the S&P 500 index are as follows (please refer to the June 2012 analysis for background information):


The earnings yield and the dividend yield increased 0.38% (0.02 percentage points) and declined 0.86% (0.01 percentage point) respectively from that reported on 4 February 2013. The current earnings yield is 25.92% lower than the historical average since 1978 while the dividend yield is 36.27% lower. The two combined therefore indicate the current market valuation of the S&P 500 is significantly higher than average. Furthermore, removing the 1998 to 2000 period, a period when the stock market was extraordinarily high compared to fundamentals, the current earnings yield is 29.79% lower than average while the current dividend yield is 39.47% lower on the same basis.





The Spread as of 6 March 2013
The spread, the difference between earnings yield and the 10-year treasury yield (GS10), widened slightly since the previous report, from 2.37% to 2.43%. The spread still remains considerable higher than the average negative spread of 0.92% since 1978. One (of many) likely reasons for this, as reported many times before, is that bond yields are artificially low due to the support from the Fed. In a historical perspective, the spread indicates the current market valuation of the S&P 500 index is substantially lower than average and that equities as measured by the S&P 500 index remains more attractively valued than 10-Year treasuries.





Conclusion
As there were only minor changes in the ratios since the previous report, there are few reasons to change the conclusions from the 4 February report when we concluded:
Based on 10-year trailing earnings- and dividend yields, the S&P 500 is now becoming increasingly pricey compared to historical averages following the January stock market rally. For the long term investor looking to buy into the S&P 500 index, the current valuation is not attractive and there likely will be (in due course) better opportunities to enter the market. For those that are already invested in the index, it might be time to sell or reduce any positions.
In any case, being selective about what stocks to buy is becoming increasingly important given the overall high stock market valuation based on the S&P 500 index. Historical averages these days arguably matters less than usual as these are unusual times due to Fed policy aggressively attempting, and succeeding, in keeping interest rates low through its purchases of treasury securities and keeping the Federal funds rate near zero. This serves to make equities relatively attractive compared to treasury yields and the continued increases in money supply and the still relatively high spread mentioned above could very well drive U.S. equities substantially higher from here. Certainly, given the choice between buying 10-year U.S. treasury securities at a yield of around 2% or lower and companies with strong track records, earnings yields substantially higher than 2% and with sensible balance sheets, the latter is preferable.
The Fed presumably cannot go on forever with its asset purchase programs as increases in base money and the money supply could cause a substantial increase in consumer prices, especially if employment numbers improve substantially. And with the federal debt continuously increasing, the markets will perhaps in due course demand a higher yield on treasury securities (the 10-year yield has already increased in recent months). The spread between earnings yields and treasury yields will then narrow further making equities even less attractive than currently. An increase in interest rates this time around might mean (some) investors, to the extent possible given portfolio constraints if relevant, rush out of treasuries and into equities. Under this scenario and with confidence returning and/or the risk of consumer price inflation increasing, equities could move substantially higher as investors seek higher returns and some protection against increasing prices.
In conclusion, there are as always many factors at play here, but making it simple and looking purely at valuations, the stock market is now expensive in a historical perspective which means this is in general not a good time to be invested in U.S. equities. But if you do decide to invest or continue to be invested in equities, be diligent and very selective about which stocks you chose. Valuations matters under any scenario.
Finally, the Dow Jones Industrial Average and many of the Wilshire indices hit new all-time highs this week which further indicates U.S. stocks in general are by no means cheap at this stage. This is in general not a good sign for future returns for the long term investor who buys at such levels.