Wednesday, 5 June 2013

The Spread Drops as Treasury Yields Rise: 10-year Average Earnings- and Dividend Yields, S&P 500 (as of 4 Jun-13)

Earnings - and dividend yields as of 4 June 2013
Based on the closing price of the S&P 500 index of 1,631.38 on 4 June 2013 and data from Professor Robert Shiller's home page, the current 10-year average real earnings- and dividend yields for the S&P 500 index are as follows (please refer to the June 2012 analysis for background information):


The S&P 500 index increased a modest 0.33% since our last report issued on 8 May. As a result, the 10-year average earnings yield declined by 4 basis points to 4.18%, the lowest yield recorded since January 2008 and 29.70% lower than the long term average since 1978. Removing the 1998 to 2000 period (when valuations were extremely high), the current earnings yield is 33.34% lower than the adjusted long term average. Stated differently, the market is now valuing the S&P 500 index 33.34% higher than it on average has since 1978 (excluding the 1998 to 2000 period).


The 10-year average dividend yield also dropped slightly since the previous report ending on 1.62% as of yesterday (down 2 basis points since 7 May 2013). The current dividend yield is 38.86% lower than the long term average and 41.90% lower than the adjusted long term average and was the lowest yield since February 2008. As with the earnings yield, the current dividend yield suggest the S&P 500 index is richly priced in a historical perspective.


The Spread as of 4 June 2013
The spread (the difference between 10-year average earnings yield and the 10-year treasury yield) declined by 15.39%, or 37 basis points since 7 May to 2.05% as of 4 June. This was largely caused by a 18.33% (33 basis points) increase in the 10-year treasury yield as longer term treasury yields have been rising rapidly of late. The current spread is the lowest reported since July 2011 when it hit 1.42%, but it remains significantly higher than the long term average negative spread of 0.89% since 1978. As we've been reporting consistently on a monthly basis for quite some time, one likely reason for the high spread is that the Fed has been keeping interest rates artificially low. In fear of future treasury yields (and interest rates in general) rising, the stock market has hence demanded an additional spread from investing in equities. Based on recent increases in treasury yields, the market has been wise to do so.




Conclusion
The major development since the previous report issued on 8 May is the substantial increase in the 10-year treasury yield and the corresponding narrowing of the spread. This serves to highlight the risk of using the spread as an indicator of over- or undervaluation as we've stated in this report many times before,
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).
And there is obviously the risk that treasury yields will continue to climb upwards. Other than this, there is little need for an updated conclusion from last time as the S&P 500 index was largely unchanged. As a reminder, readers of this report are therefore advised to read the conclusions from last month here.

On a final note, last month we discussed the distributions of future returns over the next decade based on starting P/E ratios (where E is 10-year average real earnings) as presented by Cliff Asness. We have below put together a chart based on the same data (from Shiller) covering 132 years of data (since 1881), but used the earnings yield (the inverse of the PE ratio) instead. The chart depicts the total real return earned over the next 10 years for every possible rolling decade given what the 10-year earnings yield for the S&P 500 index was at the time of investment.

The lesson from the chart is that, on average, the lower the earnings yield at the time of investment is, the lower the return over the next 10 years (and vice versa). The historical data suggest that at the current earnings yield of 4.18%, investors who buys the S&P 500 index now will on average earn a total real return over the next decade of -3.4%, equivalent to a negative real return of 0.28% a year (add your expected inflation if you're looking for a nominal yield).

It would be unwise to bet against this historical fact going forward, especially if you are a long term investor, so pick your stocks wisely if you are long the U.S. equity market (or other markets as well since the S&P 500 index has a nasty habit of dragging other stock markets up and down with it).


See also: S&P 500 Returns with and without Money Printing

And remember to watch money supply developments closely.


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