As discussed in detail last summer (see Research Highlights and Forbes article), comparing the Earnings Yield on stocks (using the S&P 500 Cyclically Adjusted Earnings Yield [CAEY]) to the Risk-Free Yields on U.S. Treasury Bonds can have an elucidating effect on an investor's favor towards equities or away from them. Recall that Earnings Yield is equal to Earnings Per Share divided by its Stock Share Price. By simply inverting the Price-to-Earnings (PE) Ratio, you attain the Earnings Yield, which standardizes a stock's attractiveness as a cash flow instrument (typically stocks are bought for capital growth or dividend yield or some combination thereof) relative to other cash flows instruments (typically bonds for fixed income purposes).
In Figure 1 (below), the differential relationships between the S&P 500 CAEY and three main risk-free rates in the U.S. are illustrated for the ten-year period ending July 31, 2024. Additionally, the main section of the chart shows the raw data series focusing in on just one risk-free rate (e.g., 5-Year U.S. Treasury) versus the S&P 500 CAEY. The basic premise is that when risk-free rates are offering better cash flows (or, yields) than the cash flows offered by stocks (whether those cash flows are paid out in the form of dividends or not is not analyzed here), a rational investor would choose to allocate more towards the risk-free rate to benefit from more favorable returns per unit of risk. (U.S. Treasuries are assumed to be risk-free by capital market participants [although this point is hotly debated elsewhere]).
In Figure 2, another version of the S&P 500 Earnings Yield is shown, which represents the forward estimate of this metric and non-cyclically adjusted (as is the case of the Shiller Cyclically Adjusted Earnings Yield). We prefer referencing Shiller's CAEY in formulating our market outlook as it averages out earnings over the prior ten years on a rolling basis, thereby reducing short-term events, shocks, and accounting adjustments. That being said, the Forward Estimate on the S&P 500 Earnings Yield (below) shows a significant increase between now and year-end 2025, when the value is projected to be at 4.56%. It is assumed that stock price levels remain constant while earnings are projected to increase, which results in a growing metric. However, we do know that this Earnings Yield level could also grow to such a lofty figure through a falling denominator (P) while its numerator (E) remains unchanged. We make no judgement on how the attainment of a more favorable yield is attained. But as rational investors, we would allocate accordingly.
There's a historically observed dynamic in the capital markets where "flight-to-safety" trades inherently decrease risk-free yields (as bond prices move inversely to their yields), while simultaneously increasing Earnings Yield (as stock prices decline even with their somewhat stable-to-lackluster earnings). Such is a scenario that our ACGM Total Portfolio Solutions Suite™ is currently positioned to exploit further over the next several months. Part of our thesis is that the full impact of the restrictive monetary policy imposed on the U.S. economy since March 2022 has been mostly ingested, as highlighted by consumer demand data and unemployment data. These macro factors would continue to disappoint stock investors during subsequent quarterly earnings calls, as it specifically relates to the Top 10 stocks (by market cap) in the S&P 500.
Fig. 1
Fig. 2
Copyright © 2024, Ivan Illan, AWAIM®