In a Digest last week, we suggested it’s time to get your rainy-day plan ready in case the market rolls over. As part of the rationale, we pointed toward historically high price-to-earnings valuations. But did you know that you can invert this ratio to analyze the market in a different way — something called the “earnings yield”? Our technical experts, John Jagerson and Wade Hansen, focused on this earnings yield in their Strategic Trader update earlier this week. Interestingly, it’s telling investors something very different than its inverted cousin. In fact, the earnings yield gives John and Wade reason to believe that the S&P can continue its bullish run well into 2021. So, what are all the details? That’s what you’ll find out in this Sunday edition of the Digest. I’ll let John and Wade take it from here. Have a good weekend, Jeff Remsburg

 

Afraid of the S&P 500’s High P/E Ratio?

By John Jagerson and Wade Hansen

The S&P 500 hit new all-time highs today (Wednesday) as Wall Street prepared for the inauguration of Joe Biden as the 46th President of the United States.

This is great news for stock-market bulls, but it has a lot of traders wondering just how high the stock market can go.

Many traders point to the S&P 500’s soaring P/E ratio as a huge red flag that the market is due for a pullback. Looking at the chart in Fig. 1, you can see that with a P/E ratio of 38.28, the S&P 500 is approaching dot-com bubble territory.

Fig. 1 — S&P 500 P/E Ratio — Chart Source: multpl.​com

However, while it’s important to pay attention to this dramatic rise in the S&P 500’s P/E ratio, we also need to put it in context.

Searching for Higher Yields

Traders are always searching for higher yields.

The baseline yields traders typically use when assessing their investment opportunities are Treasury yields, like those represented by the CBOE 10-Year Treasury Note Yield Index (TNX), because they know that Treasurys provide a reliable yield, backed by the full faith and credit of the United States government.

Treasury yields fluctuate as inflation, monetary policy and economic growth expectations change.

For instance, the TNX collapsed to an all-time low of 0.40% on March 9, 2020, after the coronavirus virtually shut down the U.S. economy (see Fig. 1).

Fig. 2 — Daily Chart of the 10-Year Treasury Yield (TNX) — Chart Source: TradingView

 

Now that multiple coronavirus vaccines are being distributed and the U.S. government looks ready to allocate even more stimulus money, the TNX has climbed back above 1%. It still has a long way to go to fully recover, but it’s a start.

The yield on the TNX may still be low, but it establishes a baseline. Once traders have identified their baseline, they are then able to evaluate the yield on other investment yields, like the stock market, to see if they are attractive, or not.

But how do you determine the yield of the stock market?

You look to the earnings yield, which is the earnings the market generates, compared to the price you are paying for those stocks (i.e. the E/P ratio).

If you’ve never heard of the E/P ratio before, you’re not alone. But even if you haven’t, it should look at least vaguely familiar. That’s because it’s the inverse of the P/E ratio.

Finding the Earnings Yield

You can determine the current earnings yield of the stock market — as measured by the S&P 500 — by finding the inverse of the S&P 500’s current P/E ratio.

For instance, according to multpl.​com, the current P/E ratio for the S&P 500 is 38.28 (see Fig. 1).

Now that you know the P/E ratio, all you do is find the inverse of this number to determine the earnings yield on the S&P 500, which in this case is 2.61% (1 / 38.28 = 0.02612). You can also see a graphical representation of this on multipl.com (see Fig. 3).

Fig. 3 — S&P 500 Earnings Yield — Chart Source: multpl.​com

Don’t Forget the Dividends

Now, we don’t want to forget about dividends because they play an extremely important role in your overall profitability in the stock market. According to multipl.com, the dividend yield for the S&P 500 today is 1.53% (see Fig.4).

Fig. 4 — S&P 500 Dividend Yield — Chart Source: multpl.​com

 

If you add the yield on earnings from the S&P 500 — which is 2.61% — and the yield on dividends from the S&P 500 — which is 1.53% — you get a total yield of 4.14% (2.61% + 1.53% = 4.14%).

So … is 4.14% a good yield?

Traders try not to be foolhardy with these investments. They demand a premium for the increased risk they are taking by putting their money into stocks instead of bonds. This “risk premium” can vary quite a bit depending on market conditions.

Looking at the chart in Fig. 5, you can see that risk premiums (yellow line) increased after the dot-com bubble burst and again after the 2008 Financial Crisis as traders became more cautious in their stock investments.

Fig. 5 — S&P 500 Dividend Yield — Chart Source: TradingView

 

However, after topping out at 7.53% in September 2011, risk premiums have been moving lower as traders have become increasingly confident in the stock market and have been unable to generate much yield in the bond market. Risk premiums jumped briefly to 5.6% in April 2020 after the start of the coronavirus pandemic, but they have been falling ever since and are near their lowest levels in a decade.

During the past 20 years, the risk premium has averaged 3.11%.

Using that number as a benchmark, if a trader can earn 1.1% on her money by buying virtually risk-free 10-year Treasurys today and were to demand a risk premium of 3.11% to invest in stocks, then those stocks would have to yield at least 4.21% (1.1% + 3.11% = 4.21%) to still be attractive.

When you compare the current 4.14% return a trader could get from the S&P 500 with the 4.21% return an investor would demand if she could earn 1.1% on her money by buying virtually risk-free Treasuries and demanded a risk premium of 3.11% to invest in stocks, you can see the numbers are right in line with where you would expect them to be.

The Bottom Line

While the S&P 500 has a rather high P/E ratio compared to where it has been in the past, we think it can still climb higher during 2021 if Congress passes a new stimulus package and companies continue to beat earnings expectations.

Sincerely,

John Jagerson and Wade Hansen
Editors, Strategic Trader