Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
EQ: In this week’s Sector Watch, you examined the earnings yield of the S&P 500 versus that of the 10-year Treasury bond, and found that stocks are yielding almost three times as much as Treasury bonds right now. How rare is this occurrence? When was the last time that ratio was this high?
Stovall: The earnings yield is the inverse of the P/E ratio, meaning that its earnings divided by price rather than price divided by earnings. Right now, the earnings yield on the S&P 500 is 5.4 percent, which is almost three times as high as the 1.9 percent that the 10-year Treasury note is yielding. Going back to 1945, the average multiple is 1.6, as compared with the 2.8 that we have today. The last time that we had such a large multiple was back in 1955, so we’ve been trading in a much narrower range over close to 60 years.
EQ: Based on past observations, what does this suggest about the market’s possible direction going forward?
Stovall: The common wisdom holds that if stocks are yielding a lot more in earnings than bonds are in interest rates, then stocks are attractive from an asset-class perspective. So I went back to 1945, and I put the earnings yield versus bond yield multiple into three areas: high (2.0 and over), medium (1.0 to 1.9), and low (0 to 0.9) categories. Basically, what I found is when you are in the highest third—as we are today—the average forward 12-month price change was a gain of close to 12 percent. Also, this increase occurred 71 percent of the time. Of course, history is a guide, but never gospel.
EQ: Looking at this information in which stocks, from an earnings perspective, are giving investors almost three times as much than bonds, does it makes any sense for investors to be in Treasuries right now?
Stovall: There is a reason to be in Treasuries. Certainly, investors will say that if you have an exposure to short-term Treasuries, then if we do start to see interest rates rise, then they will not be hit as hard as longer-date Treasuries. Plus, we really don’t see rates rising as dramatically because we think the Fed is going to keep interest rates low until 2015.
Also, Treasuries really still remain among the only asset classes that have negative correlations to equities during bear market periods. So one could convince themselves that they need to have some exposure to Treasuries, but what I think this study is indicating is that if you’re looking to squeeze out the greatest price appreciation in the next 12 months, you have a greater chance of achieving that through stocks than through bonds.
EQ: Looking at the 10 sectors and the premiums they’re offering when comparing EPS to bond yields, is that attractive right now or is that number going to come down?
Stovall: Right now, all 10 sectors on the S&P are trading at an earnings yield-to-bond yield multiple that is above 1. Those that are actually posting a current multiple today versus their long-term average that’s above 100 percent are predominantly your cyclical sectors. The two strongest ones are Information Technology at close to 200 percent, and Financials, which are trading at a multiple that is more than 150 percent higher than what it normally is.
My belief is that if these cyclical sectors are trading at a much higher-than-normal earnings yield-to-interest rate yield going back to the mid-1990s, then the indication is that possibly the most recent rotation into the cyclical sectors from the defensive sectors has some sustainability. In general, I think that the stock market could outperform the bond market because of the very wide earnings yield differential, and then within the market itself, the cyclical sectors look as if they are sporting much more attractive earnings yields than they historically do.
EQ: Considering that this rotation is happening during May, which is traditionally more favorable for defensive sectors, does this trend indicate a more bullish signal for investors overall?
Stovall: What it indicates right now is that you can’t time exactly when a market is going to peak or trough. Historically, the market has had its seasonally weak stretch in the six-month period of May through October, and traditionally it has had its strongest seasonal period between November and April. This time around, things could be different. That’s just part of stock market history. It just doesn’t always work out the way the probabilities would indicate.
Also, what we might find is that rather than a “sell in May” signal, we experience a “swoon in June”. Or, maybe we’ll end up seeing the softness start a little bit later in 2013, whereas we saw the softness occur a little bit earlier in 2011. So there’s no exact timing as to when strength or weakness will actually start, but in general, the market tends to be a little bit more conservative, if you will, in the summertime months.