Baa bonds vs S&P Forward Earnings

I’ve kept track of the S&P forward earnings and the yield on Baa bonds as valuation indicator.
Typically, the spread between these are about 1.4%.
The spread can vary, but that in itself does not appear to be a predictive indicator.
However, as the markets sold off, it wasn’t too surprising to see Baa yields rise.

Baa yield had been in the range of 3.2% to 3.3% since June of last year.
They are now about 3.67%.

Looking back in time, I see the following Baa yields:

Early Feb 2020: 3.6% (the same as now)
Nov 2019: 3.94%
Dec 2018: 5.1%

So, currently the market is essentially where it was prior to Covid: 3.6%

If Baa yields were to rise to 3.94%, then the S&P should contract ~5%
If Baa yields were to rise to 4.5%, then the S&P should contract ~14%
If Baa yields were to rise to 5.1%, then the S&P should contract ~22%

No telling if/when Baa bond yields will be at those levels.
Also, entirely possible that earnings could rise and offset the contractions.

6 Likes

I’ve kept track of the S&P forward earnings and the yield on Baa bonds as valuation indicator.
Typically, the spread between these are about 1.4%.

Bear in mind that the yield on bonds is nominal, and the yield on equities is in effect inflation adjusted.
A direct comparison between the two is pretty dodgy at any time, but particularly so when comparing
observations in a period of low inflation to a situation with substantially higher inflation.

Some companies are hurt by rising inflation and some companies benefit, but except in cases of
runaway inflation which breaks the economy, it really doesn’t matter to corporate earnings on average across the equity markets.
If all costs and all prices and all wages and all taxes rise by an extra 5%, so will profits.
Empirically, real earnings have a smooth trend for that reason–they adjust for inflation almost perfectly for time frames longer than a business cycle.

So, if you really want to compare a bond yield to a stock index yield, compare to TIPS plus a spread, not to nominal bond yields.

Geeky observation:

Equities do tend to get more expensive (for a while) when bonds get more expensive, which is not very surprising.
When yields are low in one world they tend to be low in the other.
People are clamboring for financial assets and bid them all up.

But history shows that equities aren’t worth any more when prevailing interest rates are lower.
Forward real returns from equities over decently long time frames don’t correlate with interest rates on the purchase date.
Forward equity returns do correlate very strongly with the (cyclically adjusted) earnings yield on purchase date.

So, the subtle distinction:
Low interest rates tend to explain (for as long as they last) high equity prices without actually justifying them.
I’m not suggesting you believe otherwise, just mentioning it because a lot of people get fooled by presentations from brokers.

Jim

24 Likes