STOCK INVESTORS often grow more enthused as share prices climb, which isn’t rational. After all, shoppers don’t rush enthusiastically to the department store the day after the sale ends and prices go back up.
One possible solution: Think like a bond investor. If bond yields drop from 6% to 5%, bond buyers immediately grasp that their nominal return will be lower. Similarly, stock investors might feel less cheery about rising share prices if they focus on earnings yields, which are the amount of corporate earnings they buy with every dollar invested. Earnings yields are the reciprocal of price-earnings ratios: Instead of dividing a company’s share price by its earnings per share, you divide the earnings by the price.
Those earnings might be paid out as dividends, used to buy back stock or reinvested in the business with a view to boosting future earnings growth. For buyers at year-end 2018, the earnings yield of the S&P 500 was 5%, versus 7% at year-end 2011. That means that, compared with six years ago, every dollar invested today buys you a claim on 29% less in earnings. A bond investor wouldn’t be happy to receive 29% less in interest. Shouldn’t stock investors feel the same way?
Earnings yields figure prominently in the so-called Fed model, which was popular in the late 1990s. The Fed model compares the S&P 500’s earnings yield, using forecasted earnings for the next 12 months, with the yield on the 10-year Treasury note. If the S&P 500’s earnings yield is above the 10-year Treasury yield, the model suggests stocks are more attractive than bonds.
While the Fed model retains a following among investors, its popularity has waned, in part because it doesn’t appear to have predictive power. The model also has a fundamental flaw: It isn’t clear why you should compare corporate earnings, which rise over time, with the fixed steam of interest from government bonds.
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