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The S&P 500’s current inflation-adjusted earnings yield is significantly negative, but you don’t need to worry. I point this out in order to counter a fast-spreading narrative on Wall Street that the stock market’s prospects are poor when its earnings yield — the inverse of the P/E ratio — is lower than the inflation rate. Now is one of these times: With a trailing P/E of 28.65, the S&P 500’s
SPX,
earnings yield is 3.5% — more than 3 percentage points below the Consumer Price Index’s ’s 12-month rate of change.
It is rare for the real earnings yield to be this negative, but that doesn’t mean it is bad for the U.S. stock market. The last time the S&P 500’s real earnings yield was as low as it is now was between July 1946 to June 1947, when the U.S. was emerging from its war-economy footing and inflation spiked into the double digits. That actually turned out to be a good time to load up on equities: The S&P 500’s inflation-adjusted total return over the next decade was between 13.0% and 16.0% annualized — more than double its long-term average.
The stock market hasn’t always performed this well in the wake of a negative real earnings yield. But over the past 150 years, its average return in the wake of such occasions was no different than when yields were positive. That means the real earnings yield is not a helpful indicator for predicting the stock market’s longer-term direction.
A more helpful indicator is the raw, unadjusted, earnings yield — the inverse of the P/E ratio with no adjustment for inflation. Consider the extent to which it is able to explain or predict the stock market’s inflation-adjusted total return over the subsequent decade (as measured by a statistic known as the r-squared). Since 1871, the r-squared in the case of the unadjusted earnings yield is 24.7%. In the case of the real earnings yield, in contrast, the r-squared is an insignificant 0.4%.
Stocks are overvalued
It is curious that many on Wall Street have suddenly become concerned about the U.S. stock market’s overvaluation. According to almost all measures that have a statistically significant track record, equities have been extremely overvalued for several years running. Why become worried now, on the basis of an indicator that has no statistical validity?
Their concern is reminiscent of the shock that the Claude Rains character feigns in the movie Casablanca upon “discovering” that gambling goes on in the casino.
Regardless, the market’s long-standing overvaluation makes it tricky to draw the correct lesson from the market’s low real earnings yield. Given the general overvaluation, it is entirely possible that the stock market in coming years will struggle, producing a below-average return. If it does so, however, it won’t be because the market’s current earnings yield is below the inflation rate.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
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