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To accomplish this, we need to better understand how Wall Street traders think.

Stocks aren’t the only game in town. There are bonds, real estate, cryptos, private equity deals, foreign assets, commodities, you name it…

At the end of the day, what’s important is the highest risk-adjusted return, or yield. So, how do traders assess their options from this perspective?

Back to John and Wade:

The baseline yields traders typically use when assessing their investment opportunities are Treasury yields – like the 10-year Treasury Yield (TNX) – because they know that Treasuries provide a reliable yield, backed by the full faith and credit of the United States government. 

Treasury yields fluctuate as inflation, monetary policy, and economic growth expectations change. 

The TNX has been moving higher this month as bond traders have been preparing for the potential of aggressive rate hikes. It has rebounded from its recent lows at 2.5% and is currently offering a yield of ~3.1%

(The Strategic Trader update published on Wednesday. Yields have moved higher since then. We’ll address this later.)

So, 3.1% is our starting point. This is our “risk-free” rate.

From here, investors can evaluate other investment yields.

Since the question is about stock market direction (basically, are stocks attractive relative to “safe” bonds today), let’s evaluate the stock market yield

How do we do this?

Back to John and Wade:

You look at the earnings yield – which is the earnings the market generates, compared to the price you are paying for those stocks (i.e. the E/P ratio). 

If you’ve never heard of the E/P ratio before, you’re not alone. But even if you haven’t, it should look at least vaguely familiar. That’s because it’s the inverse of the P/E ratio.

So, to find the S&P’s earnings yield, we start with its P/E ratio and then flip it.

John and Wade suggest going to a site like multpl.com to get the P/E. At the time of John and Wade’s update, the S&P’s P/E was 20.14.

Back to the Strategic Trader update:

Now that you know the P/E ratio, all you do is find the inverse of this number to determine the earnings yield on the S&P 500, which, in this case, is 4.96% (1 / 20.14 = 0.0496). 

So, we have our baseline treasury yield of 3.1%. And we have the S&P’s earnings yield of 4.96%. But we’re not ready to compare them quite yet.

Don’t forget to factor in dividends

Dividends play a huge role in the overall profitability of the stock market.

For some color on this, check out the chart below. Dating back to the 1930s and extending through the 2000s, it shows stock market returns by decade.

The first number is the return from dividends. The second number is the return from price changes.

As you can see, dividends are an enormous component of overall returns.

• 1930s: 5.4%. -5.3%

• 1940s: 6.0%. 3.0%

• 1950s: 5.1%. 13.6%

• 1960s: 3.3%. 4.4%

• 1970s: 4.2%. 1.6%

• 1980s: 4.4%. 12.6%

• 1990s: 2.5%. -15.3%

• 2000s: 1.8%. -2.7%

Source: TheBalance.com

So, what’s the dividend yield for the S&P 500 today?

Using multpl.com again as our resource, we find that it’s 1.61%.

Now, we combine the earnings yield (4.96%) and the dividend yield (1.61%) to get a total yield of 6.57%.

So, what does this mean? Is it good or bad?

There’s one final step we have to take before we reach our conclusion.

Factoring in the historical risk premium

Back to John and Wade:

Traders try not to be foolhardy with these investments. They demand a premium for the increased risk they are taking by putting their money into stocks instead of bonds.

This “risk premium” is calculated by finding the total yield (earnings + dividends) a trader can earn from the S&P 500 and subtracting the 10-year Treasury yield.

The risk premium can vary quite a bit depending on market conditions, but the average during the past 20 years has been 3.65% (see the orange line in Figure 6).

Figure 6 – Risk Premium Since February 2000

John and Wade point out how the risk premium wasn’t as large during the bull market recovery between 2003 and 2008 (the left half of the chart above, when the blue line is staying beneath the orange “average” line).

This is mostly due to the Fed allowing interest rates to rise during this period. This allowed the TNX to remain higher, which reduced the risk premium.

But after stocks recovered in the wake of the global financial crisis, the risk premium jumped (the right half of the chart above, when the blue line is mostly above the orange “average” line).

This is because the Fed kept interest rates near zero, even though stocks were climbing.

John and Wade note that the risk premium looks to be normalizing and returning to its average after swinging to extremes during the past two decades.

Putting it all together, what does it mean for the S&P?

Now that we have all the pieces to the puzzle, let’s find out what it’s telling us.

Here’s John and Wade:

If a trader can earn 3.1% on her money by buying virtually risk-free 10-year Treasuries today and were to demand the average risk premium of 3.65% to invest in stocks, then those stocks would have to yield at least 6.75% (3.1% + 3.65% = 6.75 %) to remain attractive.

When you compare the 6.57% return a trader could currently get from the S&P 500 with the 6.75% return an investor would demand if she could earn 3.1% on her money by buying virtually risk-free Treasuries and demanded a risk premium of 3.65% to invest in stocks, you can see the numbers are slightly below average but are pretty close to where you would expect them to be.

So, what does all this mean for the S&P 500, its recent decline, and the direction stocks are likely to move?

Here’s John and Wade’s:

If the TNX continues to rise, that will continue to apply bearish pressure to the stock market… However, we think it’s too early to say the S&P 500 is headed back to bear-market territory.

Since Wednesday, we’ve seen the 10-year Treasury yield climb

So, let’s re-run the numbers as of the time of this writing.

The 10-year Treasury yield now sits at 3.22%. Let’s add the historical risk premium of 3.65%. That gives us 6.87% on the bond side.

Meanwhile, the earnings yield of the S&P 500 has eased slightly to 4.94%. So too has the S&P’s dividend yield, down to 1.60%, for a total of 6.54%.

So, relative to Wednesday’s calculation, the spread has widened a bit more as the 10-year Treasury yield has climbed, making bonds more attractive. This is putting pressure on stocks as John and Wade noted.

But in their update, our experts point toward support for the S&P just above 3,900. With the S&P at 3,940 as I write, we’re nearly at that level, so not too much breathing room.

We’ll keep you updated here in the Digest.

Have a good evening,

Jeff Remsburg

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