Comments on: Felix Salmon smackdown watch, earnings-yield edition

By: MarkieMills

MarkieMills — Sat, 24 Sep 2011 10:01:56 +0000

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

By: JustinFox

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

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:

http://i52.tinypic.com/8wb68w.png

By: DavidMerkel

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.

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

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

By: klhoughton

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

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

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

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

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

http://goo.gl/Maic8

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

By: TFF

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.

By: RZ0

RZ0 — Sun, 14 Aug 2011 15:57:49 +0000

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.

By: KRF3

KRF3 — Sun, 14 Aug 2011 15:54:14 +0000

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.

By: RZ0

RZ0 — Sun, 14 Aug 2011 15:44:30 +0000

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.

By: ErnieD

ErnieD — Sun, 14 Aug 2011 15:36:26 +0000

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.