Chart of the day: The great earnings-yield divergence

By Felix Salmon
August 12, 2011
post on Monday about the huge divergence in yields between stocks and bonds, I wondered just how historically unprecedented this divergence was.

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After I wrote my post on Monday about the huge divergence in yields between stocks and bonds, I wondered just how historically unprecedented this divergence was. And now, with the help of this fabulous chart (many thanks to Nick Rizzo, Dan Burns, and Stephen Culp), it’s pretty easy to see: we’re at levels which match those at the height of the financial crisis, and which are otherwise historically utterly unprecedented.

Indeed, from 1985 through about 2002, it was just as common for the S&P earnings yield to be lower than the Treasury yield as it was for the yields to be the other way around. The two tracked each other, and the spread between them almost never moved beyond 2 percentage points either way.

In 2002, everything changed. The spread between the two jumped up to a very high level and stayed there, all the way through the onset of the financial crisis. This was the Great Moderation.

And when the Great Moderation imploded, the spread only widened further. Today, it’s about 7 percentage points. At these levels, it’s almost impossible to see how stocks could possibly be a worse long-term investment than bonds. Yes, earnings can fall. But even if they fall in half, stocks will still yield double what bonds do.

I have to admit that I really don’t understand what’s going on in this chart at all. While any given spike can always be attributed to a fearful flight to quality, that doesn’t explain the decade-long trend.

There does seem to be a feeling in the markets that current earnings levels are somehow illusory — a feeling which long predates fears of a double-dip recession. I’m not so sure about that: while earnings are surely cyclical, in the grand scheme of things corporations seem to be doing much better when it comes to earnings growth than individuals are, and I don’t see that trend reversing itself any time soon.

Even QE2 doesn’t seem to have helped on this front: while it boosted all asset classes, bonds seem to have been the primary recipients of the Fed’s flows, with stocks lagging behind.

So with the explicit proviso that I’m not going to try to explain this graph, I’ll tentatively put forward one hypothesis: that the dot-com bust of 2000-2002 had a much bigger effect on stock-market psychology than we might have thought. It made stock investors realize how fragile stocks really are, and concentrate on the risk that they could fall substantially in price. If you’re think that stocks are going to fall, then it almost doesn’t matter what their earnings yield is — you feel as though you should sell them at any price.

But frankly I don’t really believe it. There’s something more profound going on here; I just can’t put my finger on what it is.

Even without understanding what’s going on in this chart, though, it does seem to say quite clearly that now’s a good time to buy stocks, if only because the opportunity cost of not buying stocks is so enormous. Bonds and cash yield nothing: it’s really hard to see how they can be a better bet than stocks over the medium to long term. Which is not to say that stocks can’t fall, of course: they can. They can fall a lot. I’m not trying to time the market here. But the chart is striking, all the same.

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