Felix Salmon smackdown watch, earnings-yield edition

By Felix Salmon
August 14, 2011
earnings-yield chart.

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The economic historian James Macdonald emails with a very different version of my earnings-yield chart. Instead of going back to 1985, he’s found annual data all the way back to 1920. And instead of using Treasury bonds — a sui generis asset class with its own dynamics surrounding flight to quality and the like — he’s uses the yield on BAA-rated bonds instead. The result is fascinating:


Writes Macdonald:

It is not reasonable to relate earnings yields to T-bonds. They are not comparable investments. The proper comparison is with the corporate bond yields. My preference is not even AAA, since that is quite rarefied, but rather BAA – definitely investment grade but more reflective of the typical corporation and more susceptible to market jitters.

The historical pattern seems to me to be as follows:

  • a twenty-year period from 1920-1940 when bond and earnings yields were more or less comparable
  • a twenty-year period from 1940 to 1960 when earnings yields were significantly higher than bond yields
  • a twenty year period from 1960 to 1980 when the two yields were more or less comparable
  • a twenty-five year period (?) from 1980 to 2005 when earnings yields were significantly lower than bond yields. (I put a question mark, because there is also a major divergence of yields in 2009. However, I take that as a temporary aberration because of the collapse of S&P earnings during the Great Recession thanks to the losses of the financial sector).

Now the two yields are more or less the same. Are we supposed to take that as a signal to sell bonds and buy shares?

I am not at all convinced, at least on the basis of the historical evidence. We may be entering a long period when the two yields track each other. Or we may be entering a period (perhaps to be expected after a major financial disaster) when investors demand a premium yield from shares compared to bonds. In any case, the period from 1985 onwards can scarcely be taken as the historical norm, since, as we know from other statistics, such as long-term PE ratios, shares have been overvalued for almost the whole of this period.

My feeling is that a long-term period when investors demand a premium yield from shares compared to bonds is precisely the kind of period that a long-term investor wants to be putting her money into shares rather than bonds. Again, there are market timing issues here — shares might fall rather than rise for much of that period, especially during times when the premium is rising rather than falling. But if you just go back to basics and look at securities as giving you ownership of an income stream, then it seems perfectly sensible to me to pick the larger stream, given the choice.

If there’s a big risk to this strategy, it seems to me, the risk is overleveraged companies. If companies get in over their head and find themselves unable to make their interest payments, then their equity can be wiped out, and ownership transferred to bondholders. But in this particular economy, I don’t see that as a big risk — certainly not for BAA-rated companies. We saw during the financial crisis that nearly all non-financial public companies had been decidedly conservative with respect to the big debt binge known as the Great Moderation; if you were looking for massive corporate leverage, you needed to look to private equity deals.

And what if we’re just entering another period akin to the 60s and 70s, where the two yields track each other while rising? Again, I think I’d rather be in stocks, if only because they’ll do much better than bonds if and when inflation kicks in.

Finally, there’s the possibility I raised in my original chart — that stock prices are uncommonly cheap relatively to bond prices right now. Which certainly seems to be the case if you think that history began in 1985. If stocks revert to the post-1985 norm of yielding less than bonds, then moving from bonds to stocks at these levels would probably make a fair amount of sense on a mark-to-market basis. As a long-term investment, though, stocks might look a bit less attractive: you’d be less reliant on earnings and more reliant on capital gains to make up the difference.

What really surprises me about Macdonald’s chart, however, is nothing to do with the difference between stock yields and corporate bond yields, but rather the way in which nominal corporate bond yields move very slowly and smoothly. There does seem to be something reassuringly safe and reliable in that orange line. So if your priority is preservation of nominal capital, rather than maximizing your long-term net wealth, there’s something pretty attractive about corporate bonds, too.

Update: I missed this on Friday, but Jake from EconomPic Data has his own version of the chart, using T-bonds but going back even further than Macdonald does. I love this:


What happened in 1970 or thereabouts that this correlation suddenly became so strong, after barely existing before that? Could it possibly be the arrival of Modern Monetary Theory and Modigliani-Miller?


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This decade is likely to provide us with the generational opportunity for stock market investment, similar to 1932 and 1982.

That moment usually does not occur when Shiller’s CAPE and Tobin’s Q are in the top quintile of values like they have been over the past year.

Wait a few month or a couple of years and your stock earnings yield is likely to be much higher than today.

Posted by ErnieD | Report as abusive

I think you are looking at this the hard way.
I take earnings yield to mean the ratio of earnings per share to stock price, or the inverse of the price-earnings ratio.
So you seem to be restating the question of whether the P-E ratio is too high. The old saw is that the long-term P-E is 15 (equivalent to 6.7% earnings yield), so you’d buy when the P-E is lower than that and sell when it’s higher.
And as many, many others have noted, the old saw hasn’t worked to well the past couple of decades.

Posted by RZ0 | Report as abusive

I wonder about the effects of MLPs and other “new” assets which have become massively popular as of late. MLPs were huge over the last two years, for instance, and saw double-digit percentage ownership in many portfolios.

Anyway, I think you are seeing the gradual shift in the equities investor as someone who is focused less on earnings and more on shareprice. Shares have been overvalued for so long, and while the Great Recession brought them all down to some level (still, would you look at AAPL?), all that has done is create this view that there are “deals” to be had in stocks. Those “deals” though are largely pitched not as “great time to get a dividend for less,” but “wow you’ll be able to flip this stock for a 40% gain in two years!”

The huge yields in corporate debt are coming way down, BTW. Compare today to mid 2009, and you can see see things flattening out. Even without the debt ceiling crisis, this summer was “drying up” in that MLPs have returned to our atmosphere, and corporate yields are no longer blindingly attractive.

When it comes to sticking to the “larger stream,” I think you are really under appreciating the risk of that larger stream. Bonds have this beautiful way of moving to par, which means the safe stuff is safe in a way that a stock just isn’t. You can wake up tomorrow and find your 10,000 shares of ACME worth 50% what they were the day before, and that does not happen in the bond market without catastrophic fundamentals crashing down if you’re in BAA or better.

Posted by KRF3 | Report as abusive

Just to add that from 1980 to about 2008, institutional investors hated dividends and preferred companies reinvest, the common plea being “Why do you keep giving our money back to us? We have to pay taxes on it.” This sort of reasoning drives one to prefer stocks to bonds.

Posted by RZ0 | Report as abusive

Love this chart, Felix, as it starkly shows the historical variability. And it further reinforces what ErnieD and others have been saying — there is DEFINITELY room for the stock earnings yield to move higher.

Two additional thoughts:
* We’ve been riding a couple decades of corporate margin growth. What happens if the global economy turns that around and steadily squeezes margins over the next decade? (If I’m not mistaken, this happened during the 70s.) The survivors may ultimately benefit (picking up brands and market share from the losers), but you don’t want to own anything the bear catches. Anything rated Baa/BBB or lower seems pretty risky to me. (I run my own “eyeball” estimates of financial health, but they seem to roughly agree with the S&P ratings.)

* There is (justifiably) a broad gap between BBB bond yields and AAA bond yields. I’m not seeing a matching gap in valuation between BBB and AAA equities. If anything, it is the reverse — there are plenty of A and AA-rated companies with earnings yields of ~8% or higher. I’ve insisted for years that the stock market mis-prices risk, and (other than a brief correction this month) I don’t see that changing.

Hope ErnieD is right that the stock earnings yield will increase rapidly. While my retirement accounts are fully invested in equities, our taxable account has been trimmed severely over the last year to pay down our mortgage. That cash will be coming free over the next ten years, and I would love to have investment opportunities for it better than what we see today.

Posted by TFF | Report as abusive


Go ahead, you know you want to click thru…you know there’s a chart at the end of the link.

Posted by GRRR | Report as abusive

As a fund manager I can tell you this chart is bogus. Baa bonds yield on average 2%-3% for a 5 year duration. Your paradox is not solved.

Posted by cb22 | Report as abusive

Interesting update…

“What happened in 1970 or thereabouts that this correlation suddenly became so strong, after barely existing before that?”

Seems to me that the gap closed around 1960, and has remained fairly tight since then.

Also, eyeballing the chart, it seems that the earnings yield has generally *led* the Treasury yield by a couple years.

Posted by TFF | Report as abusive

To the extent that all of this was ever a mystery, it was solved years ago. The earnings yield on stocks is real, while the yield on bonds is nominal. There is no rational reason why they should track each other as closely as they did in the years leading up to 2002. See the following paper for the full argument:

The decline of inflation and the bull market of 1982-1999, Jay R Ritter; Richard S Warr, Journal of Financial and Quantitative Analysis; Mar 2002; 37, 1, page 29.

Posted by plarkin2 | Report as abusive

“What happened in 1970 or thereabouts that this correlation suddenly became so strong, after barely existing before that? Could it possibly be the arrival of Modern Monetary Theory and Modigliani-Miller?”

NO. How many times do I have to tell people this?? Did no one read their U.S. economic history?? (Possible exception for Felix, since he’s not native.)

In 1967–so basically effective from 1968 ff.–the ****ing CAP on COUPONS for long-term Government bonds was removed.

Guess what happened?

As Lyndon Johnson said in another context, “It’s not a fair race when one contestant has been running and the other has been shackled for the past ## years.”

The “equity premium” of yore is largely the product of a regulatory artifact.

Posted by klhoughton | Report as abusive

This is like my old post “The Fed Model” where I used Baa bonds. Same series.

http://alephblog.com/2007/07/09/the-fed- model/

cb22 — the bonds are noncallable Baa 20-30 year bonds in that index.

Posted by DavidMerkel | Report as abusive

I’m not sure what measure of earnings you use. It generally makes sense to use long averaging (going back 5-10 years), and possibly correct further for recession dips. And any correct chart must show the stock bubble of 1999-2000.

I made a similar chart some time ago, here it is:


Posted by Nameless | Report as abusive

I hesitate to add any explanations because plarkin2 and klhoughton both seem to have offered pretty good (if contradictory) ones, but it was in the mid-1970s that Roger Ibbotson and Rex Sinquefield first popularized the notion of the equity premium (that is, the amount by which stock returns exceed bond returns over time). As so often happens in investing, that seems to have marked the beginning of the end of the equity premium. For a while, at least.

Posted by JustinFox | Report as abusive

Just came across this – a great post – many thanks for providing this information :-)

Posted by MarkieMills | Report as abusive