If you’re having trouble understanding why the stock market keeps heading higher, try having a BEER. At the very least, it’ll give you a different perspective on the relative valuations of between stocks and bonds.
BEER is Wall Street parlance for the Bond Equity Earnings Yield Ratio. While that may sound like a mouthful, the concept is not too difficult to grasp. At its heart, this ratio compares the current yield on Treasury Bonds to the earnings yield of stocks.
In case you’re not familiar with the term, the earnings yield is simply the inverse of the P/E ratio. It tells you the percentage of each dollar invested in a stock that is earned by a company.
Read Yield Curves Painting a Bleak Picture
Here’s a quick example. If the S&P 500 is trading with a P/E ratio of 20, then the earnings yield on the S&P 500 is 5% (1/20). This means that for every dollar invested in the S&P 500, those companies earn 5 cents.
Looking at earnings this way allows for a comparison of returns between bonds and equities. It helps investors understand the value created by investing one dollar in bonds versus investing that dollar in stocks.
This approach to comparing the relative valuations between stock and bond markets was first put forth by the Federal Reserve in their 1997 Humphrey-Hawkins report. It has since come to be known as the Fed model.
In their report, they used the following chart to demonstrate the relationship in which the yield on the 10-year Treasury closely tracks the earnings yield of the S&P 500.
The tendency of these two metrics to move together led many (including the Fed) to the rough conclusion that if the earnings yield was higher than bond yields, equities were cheap, and vice versa.
The validity of this conclusion has come under question in recent years, but before getting into the details, it’s important to understand why this theoretical relationship would exist in the first place.
Stocks and bonds are typically thought of as competing asset classes. As investors, we look to maximize returns and want to invest where we will generate the most value.
When the earnings yield is higher than bond yields, it means more value is being created by investing in equities. As investors subsequently bid up stock prices, it causes P/E ratios to rise, which has the effect of suppressing the earnings yield, bringing it more in line with bond yields.
The reverse is also true. When the earnings yield is lower than bond yields, money has a tendency to come out of equities and into bonds. This reduces P/E ratios, which raises the earnings yield, again bringing it more in line with bond yields.
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Another way of looking at this relationship is through the lens of a “discounted cashflow” approach to valuing equities. When bonds yields fall, the discount rate that is applied to future equity earnings is reduced. This leads to a higher present value (share price) and a lower earnings yield.
In effect, these are really just different ways of conveying that lower bond yields induce investors to buy equities, and vice versa. In modern lexicon, with rock-bottom interest rates, we’ve come to call this TINA – There Is No Alternative (to stocks).
If we were to apply this relative valuation approach to today’s markets, we would find that the current earnings yield of roughly 4% handily beats the yield on the 10-year Treasury of 1.6%. The conclusion? Either stocks are cheap, or bonds are expensive.
Is this why the stock market continues to set new highs even in the face of paltry economic growth and deteriorating earnings? It’s certainly one plausible explanation.
But while this approach to determining the relative value between stock and bond markets remains in use today, it has many critics, and a host of data suggests the relationship may have broken down.
As you can see the in the chart below (courtesy of The Economist), the relationship between the earnings yield and bond yields has diverged in recent years. Near the turn of the century, earnings yields began drifting higher while bond yields continued to fall.
This reluctance of investors to continue bidding up stock prices (which would bring the earnings yield back down closer to bond yields) could mean one of two things. Either it’s simply taking a long time for the collective psychology of the markets to become comfortable with considerably higher stock valuations or investors don’t believe bond yields should be that low.
A chart put together by Alan Reynolds, a senior fellow at the Cato Institute (and featured on CNBC), may help shed some light on this debate.
Looking at this chart, which again shows the earnings yield vs. the 10-year Treasury yield, it appears that the earnings yield tends to lead bond yields. If this is the case, it lends more credibility to the idea that bonds yields are too low (bond prices are too high), rather than stock prices being too low.
Perhaps that’s why stock investors have been reluctant to push valuations higher in recent years. And perhaps it’s an indication that bonds really are overvalued and due for a correction.
On the other hand, the imperfect nature of this relationship also leaves room for stock markets to head considerably higher, bringing valuations between the two markets closer in line.
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