Earnings yield gap

What Is Earnings Yield Gap?

The earnings yield gap is an investment valuation metric that compares the profitability of the stock market to the returns available from long-term government bonds. It falls under the broader category of investment valuation and helps investors gauge the relative attractiveness of equities versus fixed income securities. The earnings yield gap is calculated by subtracting the yield on a benchmark government bond, typically the 10-year Treasury, from the earnings yield of a broad market index, such as the S&P 500. A positive earnings yield gap suggests that stocks may offer a higher potential return for each dollar of earnings compared to the interest offered by bonds.⁵⁰

History and Origin

The concept behind the earnings yield gap has roots in the "Fed Model," an informal valuation approach that gained prominence in the late 1990s. While not an official model from the Federal Reserve, it observed a historical correlation between the earnings yield of the S&P 500 and the yield on U.S. Treasury bonds. The underlying idea was that for the equity market to be considered fairly valued, the earnings yield of stocks should ideally be roughly equivalent to the yield on a long-term government bond, which is often considered the risk-free rate.⁴⁸, ⁴⁹ This relationship has been a subject of discussion within financial research and publications, including analyses from institutions such as the Federal Reserve Bank of San Francisco.⁴⁷

Key Takeaways

• The earnings yield gap compares the earnings yield of stocks to the yield of long-term government bonds.⁴⁶
• It serves as a tool for market valuation, indicating the relative attractiveness of equities versus bonds.⁴⁵
• A higher earnings yield gap suggests stocks may be undervalued relative to bonds, while a lower or negative gap may indicate overvaluation.⁴³, ⁴⁴
• The earnings yield is the inverse of the price-to-earnings (P/E) ratio and represents earnings per dollar invested.⁴¹, ⁴²
• While useful, the earnings yield gap has limitations and should be considered alongside other economic indicators and fundamental analysis.³⁹, ⁴⁰

Formula and Calculation

The earnings yield gap is calculated by taking the earnings yield of a stock market index and subtracting the yield of a benchmark government bond.

Where:

• (\text{Earnings Yield}_{\text{Stock Market Index}}) is typically the aggregate earnings yield of a major index like the S&P 500. This is calculated as the total earnings per share of the index divided by its current price, or simply the inverse of the index's P/E ratio.³⁷, ³⁸
• (\text{Yield}_{\text{Government Bond}}) is usually the yield on a 10-year Treasury bond, widely considered a proxy for the risk-free rate.³⁵, ³⁶

For example, if the S&P 500's earnings yield is 4.5% and the 10-year Treasury yield is 3.0%, the earnings yield gap would be 1.5%.

Interpreting the Earnings Yield Gap

The interpretation of the earnings yield gap centers on the relative attractiveness of allocating capital to stocks versus bonds.

• Positive and Widening Gap: A significantly positive earnings yield gap, meaning the earnings yield of stocks is higher than bond yields, suggests that stocks offer a greater potential return for the risk taken compared to government bonds.³³, ³⁴ This scenario might imply that equities are relatively undervalued and could be an opportune time for increasing equity exposure within an asset allocation strategy.³²
• Narrow or Negative Gap: A narrow or negative earnings yield gap, where bond yields are similar to or exceed stock earnings yields, can suggest that stocks are relatively overvalued.³¹ In such an environment, the compensation for taking on the additional risk of owning stocks might be perceived as insufficient compared to the safer, more predictable returns offered by bonds.³⁰ Investors might then consider reducing equity exposure or favoring fixed income investments.²⁹

It is important to consider that the historical average of the earnings yield gap is often positive, implying that stocks generally carry a higher earnings yield to compensate for their inherent volatility.²⁸

Hypothetical Example

Consider an investor evaluating the market at a specific point in time. Suppose the average earnings per share for the S&P 500 index is $200, and the index is trading at 5,000 points. The earnings yield for the S&P 500 would be (\frac{$200}{$5,000} = 0.04), or 4%.

Concurrently, the yield on a 10-year Treasury bond is 3.5%.

Using the formula for the earnings yield gap:

In this hypothetical scenario, the earnings yield gap is 0.5%. This positive, albeit narrow, gap indicates that, based on current earnings, the stock market offers a slightly higher yield than what can be earned from the relatively risk-free 10-year Treasury bond. An investor might interpret this as stocks still offering a marginal earnings advantage, but perhaps not a significant premium for the additional risk of equity investment. This contrasts with periods where the earnings yield gap might be much wider, suggesting a more compelling case for equity investment.

Practical Applications

The earnings yield gap serves as a macro-level investment strategy tool, helping investors and analysts to:

• Inform Asset Allocation: The gap can influence decisions regarding the proportion of a portfolio allocated to stocks versus bonds. When the gap is wide and positive, it may suggest a tilt towards equities, while a narrow or negative gap might prompt a move towards fixed income.²⁷
• Gauge Market Sentiment: Changes in the earnings yield gap can reflect shifts in investor sentiment and risk appetite. A narrowing gap, for instance, could indicate increasing demand for safer assets or a perception of elevated equity valuations.²⁶
• Compare Investment Opportunities: It provides a standardized way to compare the income potential of the broader stock market against government debt, allowing for an "apples-to-apples" comparison that is not always evident with other metrics like the P/E ratio.²⁴, ²⁵
• Contribute to Valuation Models: While simple, the earnings yield gap is a foundational component of more complex valuation frameworks, including the Fed Model. Financial data providers like Morningstar often provide data and analysis on market earnings and bond yields to assist investors.²³

Limitations and Criticisms

While the earnings yield gap offers a straightforward comparison, it has several limitations and has faced criticism:

• Ignores Growth and Dividends: A primary critique is that the earnings yield gap, particularly the earnings yield component, focuses solely on current earnings and does not inherently account for future earnings growth or dividend yield.²¹, ²² Companies often reinvest earnings for growth, which can lead to capital appreciation not captured by the earnings yield.²⁰
• Not a Reliable Predictor of Short-Term Returns: Historical analysis suggests that the earnings yield gap, or the broader equity risk premium it often approximates, does not consistently predict future stock returns, especially in the short term.¹⁸, ¹⁹ Periods with low or even negative gaps have sometimes preceded strong equity performance.¹⁷
• Accounting Quality and Earnings Volatility: Earnings can be volatile and influenced by accounting methods. A high earnings yield resulting from depressed earnings during a market downturn might make stocks appear "cheap," but this can be misleading if the earnings recovery is uncertain.¹⁵, ¹⁶
• Inflationary Environment: The interpretation can be nuanced depending on the inflation environment. During periods of high inflation, a larger positive gap might be expected to compensate for the erosion of purchasing power.¹⁴
• Risk Premium Nuances: The model often assumes a stable relationship between equity and bond yields, which may not hold true in all economic cycles. Critics, such as those at Fisher Investments, argue that the methodology has inherent flaws and does not fully capture the complexities of market dynamics and investor motivations.¹³

Earnings Yield Gap vs. Equity Risk Premium

The terms "earnings yield gap" and "equity risk premium" are often used interchangeably, leading to some confusion, though they have distinct theoretical foundations. The earnings yield gap, as discussed, is a direct subtraction of the bond yield from the earnings yield of a stock index. It's a simple, empirical comparison of two observable rates.¹²

The equity risk premium, on the other hand, is a more theoretical concept. It represents the expected return of the stock market in excess of the risk-free rate. It's the additional compensation investors demand for taking on the higher risk associated with equities compared to risk-free assets like government bonds. While the earnings yield minus the bond yield is often used as a proxy for the equity risk premium, the true equity risk premium is forward-looking and incorporates expectations about future earnings growth, dividends, and volatility, which are not directly captured by the simple historical earnings yield.⁹, ¹⁰, ¹¹ Therefore, while closely related and often numerically similar, the earnings yield gap is a descriptive metric, whereas the equity risk premium is a more conceptual, forward-looking measure of required compensation for equity risk.

FAQs

What does a negative earnings yield gap mean?

A negative earnings yield gap occurs when the yield on government bonds is higher than the earnings yield of the stock market.⁸ This suggests that safer Treasury bonds are offering a greater "return" than what the stock market is generating in earnings, which can indicate that stocks are relatively overvalued or that bonds are particularly attractive.⁶, ⁷

How does the earnings yield gap relate to the P/E ratio?

The earnings yield is the inverse of the price-to-earnings (P/E) ratio.⁴, ⁵ For example, if a company has a P/E ratio of 20, its earnings yield is 1/20 = 0.05, or 5%. The earnings yield gap uses this percentage-based earnings yield for stocks, making it directly comparable to bond yields, which are also expressed as percentages.³

Is the earnings yield gap a definitive buy/sell signal?

No, the earnings yield gap is not a definitive buy or sell signal. While it can offer insights into the relative attractiveness of stocks versus fixed income, it is one of many tools investors use for market valuation. It does not account for all factors influencing investment returns, such as earnings growth expectations, dividends, or specific company fundamentals.¹, ² It is best used as a broad directional indicator rather than a precise timing tool.