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The rally that just won’t quit continued again last week. In fact, last Monday marked the 177th straight session without a 5% pullback, breaking the previous record stretch of 176 days set in 2010. That’s an incredible record to break.
Though the indices have risen at a fast clip, stocks remain a good value. The Standard & Poor’s 500 has a 5.4% earnings yield (EPS/price). Investors look at the earnings yield – as opposed to its inverse, the P/E ratio – to determine if they are being rewarded for taking extra risk. So a high earnings yield lures investors into stocks, promoting further price appreciation.
For point of reference, the earnings yield has been above 6% between 2010 and 2012, while it was 1.6% and 4.6% in 2008 and 2009, respectively. All of 2008 and parts of 2009 were tough on stock prices. Conversely, most indices have glided higher during every look-back period since 2009 (the S&P 500 has gained 47% since January 2010).
Though the current 5.4% earnings yield (based on 12-month trailing EPS) isn’t high by recent historical comparisons, it’s more than twice the 10-year Treasury yield of 1.98%, meaning that stocks remain very attractive compared to government bonds.
In fact, Capital IQ reports that the S&P 500 averages an 11.8% gain during the ensuing 12 months when the earnings yield is double the 10-year bond yield. Moreover, the senior index sported gains 71% of the time when the earnings yield was at least twice that of Treasuries.
Fed Chairman Ben Bernanke is mostly to thank for the disparity between the earnings yield and 10-year rate. The Fed has kept a lid on government interest rates, and experts aren’t expecting that strategy to shift any time soon.
Because the Fed is depressing Treasury rates, earnings are the main focus because they are more likely to change. So long as earnings can stay high and improve, the ratio between the earnings yield and 10-year Treasury yield will remain above two. And if history is any predictor, stock prices will move higher at a double-digit clip until that ratio contracts.
Fortunately, corporate results and economic reports have been positive. Companies are surpassing analyst EPS estimates, although sales growth has been poor. The Bespoke Investment Group says that 59% of reported companies beat EPS estimates, while only 52% beat sales expectations. Though an unfriendly job atmosphere has been a wet blanket on consumer spending, corporations have cut costs, driving profitability higher.
Analysts expect EPS growth to continue this year. The consensus EPS estimate for the S&P 500 is $111 this year and $115 for 2014, leaving the index with earnings yields of 6.7% and 7%, respectively, based on current prices. That means that the S&P 500 could rise to 2,875 (more than 70% above today’s price!) next year and still have an earnings yield that’s twice that of the current 10-year Treasury rate.
It’s hard to believe there is more upside left, considering this year’s rally. And the indices may be wildly overbought in the near term. However, stocks could have a few more years of big gains ahead. I’d recommend buying the dips because the risk-to-reward based on earnings yield favors equities.
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