Tuesday, 3 December 2013

Downside Risk Increases Again: 10-year Average Earnings- and Dividend Yields, S&P 500 (as of 2 Dec-13)



Earnings - and dividend yields as of 2 December 2013
Based on the closing price of the S&P 500 index of 1,800.90 on 2 December 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):


Real Earnings- and Dividend yields (10-year rolling averages) as of 2 December 2013
The S&P 500 index increased 2.15% since the previous report in this series was issued on 5 November (based on data from 4 November). As 10-year average real earnings remained largely unchanged, the real earnings yield declined 8 basis points, or 2.03%, during the period. At 4.01%, the earnings yield remains the lowest it's been since December 2007 and is now 32.35% lower than the average since 1978. Removing the 1998 to 2000 period (when market prices were "off the charts"), the current earnings yield is 35.80% lower than the adjusted average since 1978.


The 10-year average real dividend yield also declined since last month, predominantly as a result of the increase in the S&P 500 index, but also due to a 0.75% decline in 10-year average real dividends. The current dividend yield of 1.51% was also the lowest since December 2007 (when it was 1.43%) and is now 42.82% and 45.61% lower than the average and adjusted average since 1978.


The Spread as of 2 December 2013
The spread, the difference between the 10-year average real earnings yield and the 10-year U.S. treasury yield, narrowed by a whopping 16.20% (23 basis points) since 4 November to close at 1.21%. This narrowing of the spread was driven by the 8 basis points decline in the earnings yield discussed above and a 15 basis points increase in the 10-year treasury yield which increased from 2.65% last month to 2.80% as of yesterday. The spread remains the lowest it's been since May 2011, but also remains substantially higher than the average negative spread of 0.86% since 1978. As mentioned many times previously in this report, the relative high spread in recent years is most likely the result of interest rates being driven artificially low by the Fed.




Conclusion
Following another solid month for the S&P 500 index, the index is now at its most highly valued by the market for almost six years based on 10-year average real earnings and dividend yields. Increasingly, especially during the last couple of months, the price has become disconnected from fundamentals. As a result, the downside risk to future returns increased further during the last month. At current levels all margin of safety is long gone and a significant drop in the index of 25% or more is not too difficult to imagine from here.