We would argue the most popular way to value individual stocks and the stock market is using earnings,  with investors taking what a company or the market has earned (“reported earnings”) or what a company  or the companies that make up the market are expected to earn (“estimated earnings”) and applying a multiple (“Price to Earnings” or “P/E Ratio”) to that number and arriving at how a company or the market is valued or how they think a company or the market should be valued, typically using the S&P 500 as a proxy for the broad market. Investors often disagree about what constitutes a “fair” multiple for a company or the market, but most agree a low interest rate environment supports a higher multiple, which is one of the reasons we feel the S&P 500 isn’t overvalued at 17x its next twelve month  (“NTM”) earnings. While using earnings is the most popular way of valuing a stock or the stock market, it  is also an absolute approach to valuation, meaning it doesn’t really help us consider the valuation of the stock market relative to other asset classes, which brings us to the point of this week’s Weekly Wire, which is Earnings Yield, which is simply the inverse of the market’s P/E Ratio and a great tool for  comparing stocks and bonds and a number easily arrived at. For example, if the S&P 500 is at 3,037 and  Wall Street expects the index to produce $176 in EPS over the NTM it has a NTM P/E of 17x (3,037/$176) and an earnings yield of 5.8% ($176/3,037).

Since the two asset classes of greatest importance to most US investors are US stocks and US bonds –  one has historically been a hedge against the other and US investors are most impacted by how our markets are doing – it makes sense to think about the valuation of US stocks and US bonds on both an absolute basis and relative to each other, which brings us back to the earnings yield of the S&P 500 and how it compares to the yield of the US 10-year note. At the end of October, the 5.8% earnings yield of the S&P 500 was more than 400 basis points – or 4% — higher than the yield of the US 10-year note (5.8% –  1.70%), and historically such a positive spread has indicated US stocks are attractively valued relative to bonds. To put the spread between the earnings yield of the S&P 500 and the yield of the US 10-year note in greater historical context, just before the stock market bubble of the late 1990s burst the yield of the US 10-year note EXCEEDED the earnings yield of the S&P 500 by more than 200 basis points.

We continue to believe that US stocks are reasonably valued on an absolute basis, and attractively valued  relative to traditional fixed income.

Download the weekly wire

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Brinker Capital, Inc., a registered investment advisor.

Tagged: Tim Holland, market perspectives, S&P 500, earnings yield, earnings, 10-year note