Versus Bonds, Stocks Dirt Cheap

1/30/2012


The stock market's progress will hinge on corporate America's ability to sustain its earnings momentum, and 2012 could be a very good year for stocks if investors gain confidence in consensus forecasts calling for about 9% earnings growth for the S&P 500 Index this year. Another reason we're comfortable with a mostly invested posture — stocks are cheap relative to bond yields even if earnings stagnate at current levels — is demonstrated in the tables below.

First, we compare average yields on Aaa (very high-quality) and Baa (at the low end of investment-grade) corporate bonds to 10-year Treasury bonds. As shown, today's yields are very low versus the norms since 1996, and the spread between Baa and Treasury yields is well above historical norms.

Second, we show average and median earnings yields for stocks in the large-cap S&P 500 and all-cap S&P 1500 indexes. Earnings yields, based on trailing 12-month earnings, are the inverse of price/earnings ratios. As shown, the median stock in the S&P 500 has an earnings yield of 6.5%, meaning one-half are above that level. That compares to a 15-year norm of 5.6%, and today's median is higher than all but 10.5% of the month-end observations since 1996.

Third, we look at the spread between Baa bond yields and earnings yields on stocks. As shown, the median earnings yield on S&P 500 stocks exceeds the Baa yield by 1.2%. That is a reversal of the normal relationship, as Baa yields have exceeded the median S&P 500 earnings yield by an average of 1.4% since 1996.

Conclusions

All else equal, for the average S&P 500 earnings yield to return to the norm since 1996, the average stock would need to climb 20%. For the average S&P 500 earnings yield to return to its normal spread versus Baa bond yields, the average stock would need to climb 90%.

While all else is never equal, the fact that stocks are so cheap relative to current bond yields provides a measure of protection should earnings disappoint or bond yields jump. For now, with the Dow Theory in the bullish camp, our buy lists have 85% to 88% in stocks.


BOND YIELDS AND CREDIT SPREADS

Yield of
10-Year
T-Bonds
(%)
Avg. Yield
of Aaa
Corp. Bonds
(%)
Avg. Yield
of Baa
Corp. Bonds
(%)
Baa Yield
Minus
T-Bond
Yield
(%)
Recent
2.1
3.9
5.3
3.2
Norm since 1996
4.6
6.1
7.1
2.5
% of month-ends higher
99.0
99.5
98.5
12.5

 

EARNINGS YIELDS ON STOCKS

----- S&P 500 Stocks -----
---- S&P 1500 Stocks ----
Average
EPS Yield
(%)
Median
EPS Yield
(%)
Average
EPS Yield
(%)
Median
EPS Yield
(%)
Recent
5.9
6.5
5.2
6.1
Norm since 1996
4.9
5.6
4.8
5.7
% of month-ends higher
7.3
10.5
12.5
20.4

 

EARNINGS YIELDS VERSUS BONDS YIELDS

----- S&P 500 stocks -----
----- S&P 1500 Stocks -----
Average
EPS Yield
Minus
Baa Yield
(%)
Median
EPS Yield
Minus
Baa Yield
(%)
Average
EPS Yield
Minus
Baa Yield
(%)
Median
EPS Yield
Minus
Baa Yield
(%)
Recent
0.6
1.2
(0.1)
0.8
Norm since 1996
(2.2)
(1.4)
(2.3)
(1.4)
% of month-ends higher
2.7
4.2
2.1
4.2

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