Most investors understand what a price-to-earnings ratio (P/E) is. A measure of value, P/E is nothing more than a stock or index price divided by earnings. When we buy a business, we do so in the hopes of sharing in that company’s earnings. We hope that earnings will grow, or that earnings stay the same and provide us with income in the form of dividends. We can compare P/E ratios across companies, industries, and indexes. Companies that we hope will have high future earnings typically have high P/E ratios.
How do we compare companies with other types of investments though? One way is to compare low-risk investments, Treasury bills for example, to the earnings on stocks. For that, we can use the inverse of P/E, which is called the earnings yield. We derive the earnings yield by dividing the trailing earnings of a company, index, or sector by the price.
The earnings yield has meant little since Quantitative Easing (QE) drove short-term interest rates to near zero. In Europe, we saw negative interest rates. Even companies that made nothing, but were expected to make money in the future, were desirable under those circumstances. Nasdaq posts the earnings yield for the S&P 500 on its website, so I shall use that index to illustrate it's importance.
On December 31, 2011, the earnings yield of the S&P 500 was 6.99. The St. Louis Fed informs us that the 3-month T bill paid .02% on that day. The earnings yield dramatically favored stocks over bonds as we began 2012. The earnings yield for the period April-June of this year is 4.14 according to Nasdaq, while the 3-month T bill paid 5.07% on June 15. A basic tenet of economics is that we should demand a significant premium if we are taking more risks than safer investments. The earnings yield does not look so hot even when compared to the 10-year Treasury, which paid 3.73% on June 15.
The last time that I remember the earnings yield being so out of balance was right before Y2K, which is more than two decades ago. Few people under the age of 50 have experienced such a world. To restore the balance that we have become accustomed to since the Great Recession, earnings need to rise and interest rates need to come down. Earnings may rise, but I do not see interest rates coming down. In fact, I think that we could see a surprise in interest rates to the upside before the end of the year. We have certainly seen that elsewhere in the world.
data.nasdaq.com/data/MULTPL/SP500_EARNINGS_YIELD_MONTH-sp-500-earnings-yield-by-month