Wednesday, 8 May 2013

Yields hit Five Year Low: 10-year Average Earnings- and Dividend Yields, S&P 500 (as of 7 May-13)


Earnings - and dividend yields as of 7 May 2013
Based on the closing price of the S&P 500 index of 1,625.96 on 7 May 2013 and data from Professor Robert Shiller's home page, the current 10-year average earnings- and dividend yields for the S&P 500 index are as follows (please refer to the June 2012 analysis for background information):



Following a 4.1% increase in the S&P 500 since our last report on 2 April, the 10-year average earnings yield dropped further. At the current 4.22%, it is the lowest earnings yield recorded since May 2008, five years ago. Compared to the average earnings yield since 1978 of 5.95%, the current yield is 28.99% lower. If we exclude the 1998 to 2000 period (a period when the stock market was extraordinarily high compared to fundamentals) the current earnings yield is 32.68% lower than the adjusted average earnings yield. 



The 10-year average dividend yield dropped to 1.64% for the month and is now 38.37% lower than the average since 1978. Removing the 1998 to 2000 period, the current yield is 41.45% lower than the adjusted long term average. As the S&P 500 climbed higher during the last month or so, the dividend yield also hit the lowest level recorded for five years. 


The current 10-year average earnings- and dividend yields therefore indicate the market is valuing the S&P 500 index substantially higher than it on average has based on those measures. 

The Spread as of 7 May 2013
The spread, the difference between 10-year average earnings yield and the 10-year treasury yield (GS10), was 2.42% as of 7 May. The spread still remains considerable higher than the average negative spread of 0.89% since 1978. One (of many) likely reasons for this, as reported many times before, is that bond yields are still artificially low due to the support from the Fed through keeping the Federal funds rate close to zero and buying treasury and mortgage-backed securities. 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 appears attractively valued relative to 10-year treasuries. But, we must highlight, the relatively high spread is due to artificially suppressed treasury yields and not due to a historically high earnings yield, which would be preferable (if price inflation was the same).





Conclusion
Last month we concluded that the stock market had become even more expensive and pointed out, in addition to the S&P 500 which had set a new all-time high, that other stock market indexes in the U.S. had rallied even more (read it here). Well, the U.S. stock market measured by all the major indexes (S&P 500, DJIA and the Wilshire indexes) have climbed higher since so it follows that the conclusion now is that the U.S. stock market is even more expensive. For example, the Wilshire 4500 Total Market Index to current GDP (Q1 2013, annualised) hit the highest level since Q1 2000 on Monday ("Approaching Bubble Territory: Wilshire 4500 to GDP Ratio Hits New All-Time High!"). 

The more expensive any stock market becomes relative to fundamentals, the lower the future probable returns become (ceteris paribus). The current 10-year average earnings yield of 4.22% equates to a Price-Earnings (P/E) ratio of 23.68. Cliff Asness, in his paper on the Shiller P/E, documents that a P/E (where E is 10-year average earnings) at the time of investing in the range of 21.1 to 25.1 (based on data from 1926 to September 2012) has historically yielded an average real return per annum for the next 10 years (including every possible rolling decade) of +0.9%, a worst case real return of -4.4% and a best case real return of +8.3%. On the same basis, but starting with a P/E of between 5.2 to 9.6, the average real return over the next decade is +10.3%, with a worst case of +4.8% and a best case of 17.5%. According to Asness, 
"...as starting Shiller P/E’s [which is based on 10-year average earnings] go up, worst cases get worse and best cases get weaker (best cases remain OK from any decile, so there is generally hope even if it should not triumph over experience!)
In conclusion, the U.S. stock market is expensive in a historical perspective and has become even more so this year. This means the probability of a downward correction and low future returns are higher than it otherwise would have been. This does not mean the stock market will not move up from here as the momentum is definitely on the stock market's side, together with the Fed (see here). But buying into the U.S. stock market in general now for the longer term resembles speculation more than prudent investing based on fundamentals.  In any case, you should not expect a high return from a buy and hold strategy of the S&P 500 index (or any other U.S. index) over the coming years.