Stocks versus bonds: Where is the value?

Stocks versus bonds: Where is the value?

hamilton-derek

Derek Hamilton

  • Managing Director, Economist — Ivy Equity Boutique
  • Read bio

There are many ways to analyze equity market valuations. One of the most common is to look at the price-to-earnings (P/E) ratio for the S&P 500® Index. One less common way is to look at the earnings-to-price ratio, also known as the earnings yield. The earnings yield for the S&P 500 Index can be a useful indicator, as it allows investors to measure the annual corporate earnings for the market displayed in the form of an interest rate or “yield.” Corporate earnings can be used by companies in several ways, including returning profits to shareholders through dividends, as well as reinvesting in the business. It is important to understand that the earnings yield is not an actual return like a dividend yield. Instead, it is a theoretical return that an investor should “earn” each year by owning a stock, or in this case, the market.

While the earnings yield is simply the inverse of the P/E ratio, using it correctly can add value. One benefit of the earnings yield is it allows investors to compare yields across different asset classes. It can be helpful to compare the earnings yield for the S&P 500 Index to the US 10-year Treasury yield. The chart below illustrates this in the form of a ratio between the S&P 500 Index earnings yield and the US 10-year Treasury yield. A reading above one implies that equities are more attractive than bonds. However, as you can see from the chart, the ratio has been above one for the past 20 years. Therefore, it may be more helpful to look at the ratio relative to recent history. From this perspective, the ratio is below the average of the past 20 years. This suggests that the rise in interest rates makes bonds look potentially more competitive versus equities, even after accounting for the selloff in the equities over the past year. Overall, this reinforces our view that the US equity market appears to be facing headwinds.

S&P 500 Index earnings yield relative to US 10-year Treasury yield

Chart

Sources: Macquarie and Macrobond.


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The S&P 500 Index measures the performance of 500 mostly large-cap stocks weighted by market value and is often used to represent performance of the US stock market.

The price-to-earnings ratio (P/E ratio) is a valuation ratio of a company’s current share price compared to its earnings per share. Generally, a high P/E ratio means that investors are anticipating higher growth in the future. Earnings yield is the inverse of a P/E ratio, capturing the ratio of earnings-to-price; it represents the percentage return based on a company’s earnings per share.

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