Equities offer a superior opportunity for investors today, particularly compared to fixed income. The earnings yield of the S&P 500 based on 2011 projected EPS is 9.4%. If adjusted for the approximately $100 of cash imbedded in the S&P, the operating earnings yield increases to 10.4%. The numbers are slightly more attractive overseas. Based on 2011 estimates, the EAFE Index earnings yield is 9.8%. If earnings grow organically from today’s depressed levels at only 5% per year (a rate that does not require the reinvestment of earnings because of current excess capacity), and even if the P/E ratio remains below the long-term average, an investor’s five year average annual return will be in the mid-teens.
By contrast, corporate bonds with fixed, taxable coupons yield much less than the growing, after-tax coupon that companies produce.
The letter includes a table comparing corporate earnings yields to corporate bond yields* at bear market lows since 1932.
When stocks have been at their lowest levels, earnings yields have been an average of 2.8% higher than Aa2 bond yields. At the beginning of July earnings yields are 4.3% above debt yields or almost twice stocks’ relative attractiveness to bonds at bear market lows. We have rarely witnessed this much disparity in the benefits of being an owner of a growing coupon versus being a lender to a fixed one.
Almost a decade ago, the earnings yield or inverse price/earnings on many quality stocks** was around 3% while corporate bonds were yielding over 7%. Today, it's not difficult to find stocks with 9% plus earnings yields compared to corporate bonds that are currently yielding less than 6%.
A complete reversal.
* Long-term corporates.
**Back then, the DJIA components collectively were more reasonably priced than the S&P 500 with an earnings yield of 5.6%. Many stocks had earnings yields of 3% or even much lower in the early 2000s. For example, the S&P 500 earnings yield was ~3% but the NASDAQ's earnings yield was...well...clearly much lower than that during the tech bubble.