Comments on: Felix Salmon smackdown watch, earnings-yield edition A slice of lime in the soda Sun, 26 Oct 2014 19:05:02 +0000 hourly 1 By: MarkieMills Sat, 24 Sep 2011 10:01:56 +0000 Just came across this – a great post – many thanks for providing this information :-)

By: JustinFox Tue, 16 Aug 2011 19:08:17 +0000 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.

By: Nameless Tue, 16 Aug 2011 19:01:49 +0000 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:

By: DavidMerkel Mon, 15 Aug 2011 17:55:59 +0000 This is like my old post “The Fed Model” where I used Baa bonds. Same series. model/

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

By: klhoughton Mon, 15 Aug 2011 17:28:15 +0000 “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.

By: plarkin2 Mon, 15 Aug 2011 13:26:17 +0000 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.

By: TFF Mon, 15 Aug 2011 12:54:39 +0000 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.

By: cb22 Mon, 15 Aug 2011 09:17:27 +0000 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.

By: GRRR Sun, 14 Aug 2011 21:15:32 +0000

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

By: TFF Sun, 14 Aug 2011 16:17:51 +0000 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.