The earnings yield of the Aussie market
Almost 12 months ago in this column I examined the earnings yield of the market, the measure often referred to as the Fed model, given it’s the measure the US Federal Reserve often looks at when assessing market valuations. The earnings yield is essentially the inverse of the P/E ratio, where earnings are divided by price to provide the percentage of each dollar invested in the market that was earned.
Essentially, the model looks to compare the gap between the earnings yield of the market and the 10-year Government bond rate. The gap or spread is often referred to as the ‘risk premium’. In simple terms, this is the premium above the risk free rate demanded by investors to take on the excess risks associated with investing in equities.
In May 2016, the ASX exerted an earnings yield of 5.07% while at the time of writing the Australian 10-year Government treasury yield was 2.22%. Therefore, the risk premium, or gap, between the earnings yield of the ASX and the 10-year bond was 2.85% at that time.
Early in 2016, global equity markets were reeling from one of the worst starts to a calendar year on record, while domestically the RBA was in the midst of implementing a monetary policy easing bias that was subsequently placing downward pressure on bond yields.
Fast forward 10 months and much has changed in global markets. As we sit here today, a rally in commodity markets has underpinned the recent strong performance of the ASX and the broader Australian economy leaving the RBA with a neutral bias. Throw into the mix inflationary green shoots globally and the prospects for US interest rates to increase faster than initially anticipated, bond yields are now threatening to end a 30+ year bull-run and beginning the make the long journey back to normalised levels.
We have just concluded the half-year reporting season and as it stands the ASX has an earnings yield of 4.20%, the lowest point in the last five years, and well below the 5.17% five year average. Once again, if we compare the 10-year Government treasury yield the explanatory power is enhanced and after rising strongly in recent months the 10-year bond rate sits at 2.86%, leaving the equity ‘risk premium’ at 1.46%.
To give it some perspective, the 5-year average ‘risk premium’ sits at approximately 2.10%, while in May 2016, the spread was a far loftier 2.85%. Therefore, we can see that over the last 10 months, the spread has narrowed significantly, leaving me to conclude that relative to history, investors aren’t necessarily being appropriately compensated for the greater risk associated with investing in equities. Over the period, equities have arguably become expensive relative to bonds, a situation we feel could limit the amount of upside we see from stock markets over the next few of months.
Published: Friday, March 10, 2017
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