What the earnings yield can tell investors about stocks

The price to earnings ratio is a useful measure to determine if a stock is cheap or expensive. The P/E ratio compares the price of the stock relative to the company’s profitability. So generally a lower P/E ratio represents a better bargain.

This valuation metric works across sectors and even entire indices as well. By inverting the P/E ratio we get the earnings yield.
This is the 1 year investment return you can expect to make by investing in the market today, assuming earnings and everything else stays the same.

Here is a chart comparing the stock market (purple line) with its earnings yield (green line) over time.

Some of the best times to invest in the stock market was when the green line was high such as in 1995, 2009, and 2011.

But as of today in July 2023, the earnings yield is close to about 5%, a fairly low number historically speaking.
The S&P 500 is currently overpriced based on historical price/earning measures, and investors can expect a return of just 5% over the next 12 months.

But this isn’t the only reason the stock market can look unfavorable to investors today.

The Equity Risk Premium is at a significant low

Something else to be aware of is the equity risk premium. This is a comparative metric which looks at how the stock market is valued relative to bonds.

The higher the risk premium, the bigger the difference between the expected returns of the stock market and risk-free investment.
For example, if the stock market’s earnings yield is 12% and government bonds are yielding 3%, then the equity risk premium is 9%.
This 9% compensates stock investors for taking the extra risk of buying volatile equities instead of safer government bonds.

And today the equity risk premium is at a 20 year low, which is pretty much at zero. 😮

That’s right. The expected 1 year stock market return is about 5%, and a 1 year government bond also pays 5%.
So why would any investor speculate in the stock market today when they can receive the exact same expected return from a guaranteed fixed income investment?

Of course there are always reasons to buy stocks even given the environment today. Maybe you think earnings will improve in the near future, increasing the earnings yield of stocks. Or you believe we’ll see additional multiple expansion in the S&P 500. So even when profits stay the same, a P/E ratio increase from 20 to 30 would produce a 50% increase in a stock’s value.

This is why Apple recently became the first company in the world to be valued at $3 trillion.

Is Apple making more money? Nope. Its sales and overall profit remained relatively flat year over year.
But its P/E multiple expanded from 25 last year to 32 today.

Last week I produced a YouTube video discussing the equity risk premium, how to calculate it, and what it potentially says about the stock market now.

It’s not that I’m bearish on stocks this year. I believe the low point of the bear market was last October. But based on where the equity risk premium is today, I would expect a pullback in the S&P 500 some time soon. Which is why I’m currently not in a rush to put any new money into the market. 🙂

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Random Useless Fact: