Thursday, 14 June 2012

10-year Average Earnings- and Dividend Yields, S&P 500 (as of 13.06.2012)


EcPoFi presents monthly this report about the earnings yield and dividend yield of the S&P 500 share index. The analysis is based on datasets published on Professor Robert Shiller's home page. The dataset is on a monthly basis both for price, earnings and dividends and quarterly figures are linearly extrapolated to monthly figures.

The 10-year average rolling earnings yield is calculated by dividing the average annual earnings during the most recent 120 months by the current price of the index where historical earnings are adjusted for inflation to reflect its nominal value today. The same principles apply to the dividend yield. A 10 year period is applied as this smooths out shorter term fluctuations in aggregate company earnings (and dividends) which better represents the long term earnings capacity for companies included in the index (read for example any edition of Graham and Dodd's book Security Analysis).

The 10 year average earnings- and dividend yields are not useful for predicting shorter term fluctuations in the stock market, but are useful ratios for identifying especially extreme over- or under valuations. In general and all else remaining the same, the higher the earnings and dividend yields the cheaper the S&P 500 index is and the lower the yield the more expensive it is. Please note that due to companies only reporting earnings quarterly, there is a lag before reported earnings are included in the E/P ratio reported here. This normally does not have a major impact on the average earnings figure due to the relatively long history of earnings applied in the ratio (but it could affect it during periods of unusually strong or poor earnings).

Earnings- and dividend yields as of 13.06.2012

Based on the closing price of the S&P 500 index of 1,344.88 on 13 June 2012, the current yields are as follows:

The current earnings yield of 4.82% is higher than the historical average since 1991 of 4.08% suggesting that the S&P 500 index is currently cheaper than average.

Source: Shiller, EcPoFi

The current dividend yield of 1.93% is slightly higher than the 1.84% average since 1991, suggesting that the current market valuation of the S&P 500 index based on dividends is largely in line with the historical average.
Source: Shiller, EcPoFi

The above yields however should be seen in relation to the general level of interest rates as one would normally expect the earnings yield to be somewhat correlated to the general level of interest rates. The chart below shows the 10 year US Treasury Constant Maturity Rate GS10 on a monthly basis starting in 1991. Although there have been some shorter term fluctuations, the general trend has been downward during the past 21 years.

Source: Shiller, EcPoFi
Subtracting the 10 year US Treasury interest rate from the earnings yield indicates the relative valuation of the S&P 500 vs Treasury yields (a variation of the "the Fed Model"). Although not theoretically flawless (see bottom of this page), the spread nonetheless provides useful insights into the current stock market valuation relative to long term treasury yields. Note the term "relative" here, as the spread does not tell you which one is over-valued or under-valued. As of time of writing, the earnings yield exceeds the treasury yield by 300 basis points. This is amongst the highest reported since 1991 and indicates that currently the stock market values earnings lower compared to the 10 year treasury than what it has done on average since 1991. But be careful with any exact interpretation: the current high spread could be due to a significant over-valuation of long term US treasuries!

Source: Shiller, EcPoFi

In concluding the above analysis, the S&P 500 is currently valued lower than what has typically been the case since 1991 when based on earnings, dividends and the spread. These factors by themselves indicate this might be a good entry point for the long-term buy and hold iequity nvestor. I say good (and not great) as the earnings yield by itself is not significantly higher than average and there could be much better buying opportunities ahead in this boom-and-bust environment which is unlikely to stop any time soon as US and EU debt problems continue unreseolved and low interest rates fuels further misallocation of capital (read: speculation). For example, the earnings yield peaked at 7.42% in March 2009, and we all know now that was a bargain (and it probably will be next time as well if it hits such a number).
Two obvious risks, from a long list, are 1) interest rates could increase (unlikely over the short-term though) and 2) earnings (and hence dividends) could drop below average in the coming years as a result of the still ongoing bank and sovereign debt crisis which could negatively affect growth. Certainly though, given an alternative of investing money in highly profitable, dividend paying companies with strong balance sheets and US Treasuries for the long term (i.e. 5 years +), I would put my own money in the former (and so I have).

Please note the following caveats/criticisms of models comparing earnings yield with treasury yields (as noted by Stimes and Wilcox in "Equity Market Valuation when discussing the "Fed Model"):
1. It ignores the equity risk premium
2. It ignores earnings growth opportunities
3. It compares an arguably real variable (the earnings yield) with a nominal value (the T-bond yield).

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