On a relative basis, even after the recent rally, US stocks still look cheap. The earnings yield on the S&P 500 is high relative to the yield available on an investment grade bond index. While this is more a function of bonds being expensive rather than of stocks being particularly cheap, the relative play still favors stocks.
Market Realist – The graph above compares the earnings yield of the S&P 500 (SPY)(IVV) and the yields offered by corporate bonds rated Aaa by Moody’s. The earnings yield is the inverse of the price-to-earnings multiple—it’s the earnings-to-price ratio. The higher the earnings yield, the cheaper the prices are, given the stock’s earnings.
The earnings yield of the S&P 500 currently stands at 5.6%, whereas the yields of investment-grade corporate bonds (LQD) stand at 4.0%. This points to the relative cheapness of U.S. equities compared to bonds, although the gap has been narrowing since Q3 of 2011.
If interest rates rise as we expect them to in the near future, equities should be preferable over bonds, including Treasuries (TLT)(IEF). Equities typically outperform bonds in high interest rate scenarios.
Please read the next part of this series to see how the steadily increasing GDP affects corporate profits.