The following is a guest post by Charles H. Dow Award winner, Wayne Whaley (CTA) of Witter & Lester. If you would like to be privy to his daily market comments and model ratings via daily email, free of charge, email him at firstname.lastname@example.org with the subject title “ADD ME TO DAILY EMAIL”.
Valuation models, particularly those that rely solely on trailing earnings, are suspect as market timing tools, as the market has historically shown the ability to stay over or undervalued before returning to historic norms. With that said, there are some relevant observations we can glean from the relationship between the ‘earning’ of bonds and equities.
Converting P/E’s to Earnings Yields
The earnings yield is a theoretical construct if we imagine that all earnings are paid to shareholders in the form of dividends. It is a valuable tool because it has measurable correlation to the prevailing interest rate at any point in time. The earning yield is calculated by dividing the earnings by the S&P or if you already have the P/E ratio, you can simply invert the P/E to get E/P.
Comparing Earnings Yield to Interest Rates
I have seen the earnings yield compared to T-bills, T-notes and T-bonds. Since the spread on these three securities has varied tremendously throughout history, I will avoid getting into yield curve analysis for this study and simply compare it to what I call an average interest rate (AIR), which is the average yield for T-bills, T-notes and T-bonds. A large positive difference would intuitively suggest equities are cheap and a negative gap the reverse:
The current spread is 2.74. It will go to some number between 3.0 and 3.25 as soon as we plug in a new number for second quarter earnings. That will be the largest spread since mid-1980.
The highest spread between earnings and AIR occurred on September 1974 with a spread of 6.95 and the S&P 500 index at 63.54. One year later the S&P was 50% higher (83.87). The lowest spread (-3.63) was at the end of the third quarter in 1987. We then proceeded to have the infamous 1987 crash with the S&P 500 index lower by 23% over the next quarter.
The current price-earnings ratio is 17.63 and headed to about 16.3 in a couple of weeks when we get a good handle on second quarter earnings. Some proponents of the secular bear market case argue that based on historical precedent, the bear market will end when the ratio is at single digits. If that is the case, it will have to be several years from now when rates are much higher than today.
This research has relevance not so much because it argues that stocks are cheap, but because it reestablishes the fact there is a relationship between the general level of interest rates and earnings.
Some would say that the above research is based on trailing earnings and the current earnings will never hold water down the road. As well, if you go back far enough in time (the 1950’s and the 1920’s), the interest rate to earnings relationship falls apart.
These points are well taken and I put very little weighting on valuation in my trading, because as I mentioned, the market can be overvalued for a long time. Valuation was negative for much of the 1990’s, yet the market tripled in that decade. In 1974, this valuation relationship peaked at 6.95 before having a 50% rally, however, the indicator was over 1 for the three previous quarters prior to that while the market dropped an additional 34%.
The valuation model that I use in my personal work takes a similar approach to the above but smooths the data a bit more and then attempts to extrapolate the past earnings into the next four quarters taking into consideration some economic variables. Valuation can give you a sign that your pitcher is in the late innings, but you should wait until the market starts having trouble finding the strike zone before you yank him. Conversely, the current market’s relative attractiveness doesn’t mean we have to go up this month, but it suggests that eventually the odds favor a resolution to the upside.
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