Higher Treasury Yields Effect on the Markets

s&p earnings yield

So you all are probably shitting your pants right about now. On Friday February 2, the S&P dropped by 1%. On Monday February 5, the S&P dropped 3% and the S&P futures continued dropping another 100 points in the after hours. Today, we experienced another 100-point drop in the S&P nearing 4%. CNBC and the media are attributing this to higher treasury yields.

What the hell is going on??

I have one theory. And again it’s only a theory. So take this with a grain of salt.

But before I introduce my theory, I’d like to introduce you all to the Fed Model. Btw, the Fed Model has nothing to do with the Fed. It was named that way by Prudential Analyst, Edward Yardeni.

The Fed Model

The Fed Model states the following:

-If the S&P earnings yield is greater than the 10-year treasury yield, then the market is undervalued. Therefore the rational investor should invest in the market.

-If the S&P earnings yield is less than the 10-year treasury yield, then the market is overvalued. Therefore the rational investor should invest in treasury bonds.

Makes intuitive sense right? Invest wherever there’s a higher rate of return. Nothing too difficult there.

So let’s compare the S&P Earnings Yield to Treasury Yields.

Btw, what is the Earnings Yield? The Earnings Yield is the inverse of the P/E ratio. So the E/P ratio if you want to call it that (Please don’t call it that)

S&P Earnings Yield vs 10-Year Treasury Yield

Using data from Quandl, we can see the S&P earnings yield has been going from 4% to 5% this year.

one year earnings yield

 

The Treasury yields, on the other hand, have been slowly creeping up this year. Historical data for our 10-year Treasury yields show that yields have increased from around 2.41% in the beginning of the year to nearly 3% now.

 

treasury yields 2018

You can see the gap between the yields have narrowed from 1.58% down to 0.80% now, nearly half the distance it was at before. The average difference between the S&P Earnings Yield and the 10-Year Treasury Yield from January 1979 to December 2008 was 0.70%. As this gap reverts towards its mean in such an aggressive manner, this might explain a shift from equities to safer instruments such as treasuries or cash.

However, there are some drawbacks to using the Fed Model:

Drawbacks of the Fed Model

The Fed model compares the 10-Year Treasury Yield, which anatomically has expected inflation priced into itself to the S&P Earnings Yield, which doesn’t. The S&P Earnings Yield is a real rate that does not include any effects of inflation. So we are metaphorically comparing apples to oranges.

It also ignores any earnings growth potential available to shareholders beyond anything after next year. Since earnings yield is just the inverse of the P/E ratio and the P/E ratio used in this model only projects forward one year.

As with all models, these are not 100% accurate. Right before the financial crisis, the S&P Earnings Yield was projecting 6-7% while 10-Year Treasury yields were forecasting 2-3%. Note that the yield curve also inverted during this time so short-term rates were much higher than long-term rates, but that’s a different story.

So What Do Higher Treasury Yields Mean?

In spite of these two weaknesses, the Fed model can still provide some useful insight. It suggests an inverse relationship between equities and bonds. If money is really going out of equities, there’s a possibility it’s being rotated into bonds. Of course this is under the assumption that bonds are providing a higher yield. At the point, the risk-averse investors will ask themselves: “Am I still being compensated for holding stocks?”

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