Friday, 12 July 2013

Earnings Yield hits Lowest Level since Dec 2007: 10-year Average Earnings- and Dividend Yields, S&P 500 (as of 11 Jul-13)

Earnings - and dividend yields as of 11 July 2013
Based on the closing price of the S&P 500 index of 1,675.02 on 11 July 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):

Since the previous report issued on 4th June, the S&P 500 index increased 2.68% and the 10-Year average earnings yield declined by 1.97% to 4.10% (from 4.18%). This was the lowest earnings yield reported since December 2007 when it was 3.85%. It is currently 31.00% lower than the 5.94% average since 1978. Removing the 1998-2000 period (when the market valuation was extraordinary high), the current earnings yield is 34.56% lower than the adjusted average since 1978. The market is therefore currently valuing the stock market index substantially higher than average. 

As the price of the index increased since the last report, the dividend yield dropped and at a current value of 1.61% the current yield is 39.39% lower than the average since 1978 and 42.39% lower if removing the 1998 to 2000 period. The current yield was the lowest reported since February 2008 when it hit 1.58%. 

The Spread as of 11 July 2013
The spread (the difference between 10-year average earnings yield and the 10-year treasury yield) declined by a whopping 31.83%, or 65 basis points since 4 June to 1.40% as of 11 July. The main reason for this significant decline in the spread, besides the 2.68% increase in the price of the S&P 500 index, was a 26.76% (57 basis points) increase in the 10-Year treasury yield which rose from 2.13% to 2.70%. This resulted in the lowest spread reported since April 2011 when the spread was 0.86%. The current spread is however substantially higher than the negative average spread of 0.88% since 1978. In the previous report in early June we wrote the following which is worth repeating, 
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.

We have for some time argued (especially during the last couple of months) that the U.S. stock market has become increasingly expensive in a historical perspective based on real earnings- and dividend yields. The stock market therefore became even more expensive as of 11 July as the S&P 500 index increased 2.68% since the previous report. As we discussed last month, the more expensive the stock market becomes the lower the likely future returns (read more here). 

The chart below depicts real (price inflation adjusted) price of the S&P 500 index and the real earnings yield. When the gap between the two becomes significant (i.e. a high market valuation relative to earnings), as in 1999/2000 and 2007/2008, the price tends to drop sharply. The current gap is now starting to resemble that from 2007/2008 and as the gap widens, future returns are likely to decline accordingly. 

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