Now that the S&P 500 is back to a five year high, investors may be wondering if stocks are still cheap. It has been a nice run since March 2009 and maybe it’s time to cash in the chips. Not so fast. We must remember that earnings on S&P 500 companies will hit a record level in 2012 and are poised to reach even higher levels in 2013. Earnings are up 22% since 2007, yet the only place where buy and hold investors have made money is from bonds. In 2007, 10 year U.S. treasury yields were over 4%, now that same bond offers you a paltry 1.87%. Even though the stock market has started off with a bang in 2013, stocks still look cheap.
One way to know is to look at the difference between the earnings yield on S&P 500 companies versus the interest yield on 10 year treasury bonds. The earnings yield is simply the inverse of the P/E Ratio. In 2012, the S&P 500 index ended the year at 1,426.21 and its cumulative 500 companies will earn $102.47 a share (based upon estimates). This gives you a P/E ratio of 13.9 (1426.21 divided by 102.47). The inverse or earnings yield, which is 1 divided by 13.9 equals 7.18%. Essentially, earnings yield answers the question, what is my return from $1 dollar of a company’s earnings? We compare the earnings yield on stocks to the yield on the safest asset that the U.S. offers, Federal government debt, called treasuries. On December 31, 2012, you could have bought a 10-year U.S. treasury bond which would pay you 1.87% a year for the next 10 years or you could have purchased an index fund/ETF based on the S&P 500 which would pay you an earnings yield of 7.18% plus a 2% dividend.
No question, the earnings yield on stocks should be more than the yield on “safe” government bonds, but the difference between the two in 2012 was the second highest in over 20 years and favours equity investors. Investors looking out the windshield instead of the rear-view mirror should be adding to their equity positions as a result.