The Wall Street Waltz: 90 Visual Perspectives, Illustrated Lessons From Financial Cycles and Trends, Revised and Updated Edition

Chart 4

Earnings Yields: Stocks versus Bonds

Is there really a meaningful relationship between interest rates and stock valuations? You bet. This chart is another visual perspective of that love affair. It highlights a most fundamental concept of investment management. For stocks to perform well, their earnings yield has to compete favorably with the interest rate achievable with bonds. Let's see how and why.

The chart shows two lines. The red line is the yield from high-grade corporate bonds from 1946–1974. The black line is the earnings yield from the S&P 500. An earnings yield is an inverted P/E ratio, or the earnings divided by the price paid to get those earnings (see Chart 43). It is expressed as a percentage, which is directly comparable to a bond yield. For example, a P/E of 20 is an E/P, or earnings yield, of 5 percent (1/20 = 0.05). The chart shows that for 20 years the earnings yield on stocks was always greater than the interest yield from bonds.

Investors normally demand a higher earnings yield from stocks than from bonds for two reasons. First, owning stocks is fundamentally riskier. Earnings can decline, hurting the stockholder's future earnings yield. But bondholders keep getting paid unless the company goes belly-up. Second, while the company may be earning plenty, you may not get much in dividends because management probably plows lots of the earnings back into the business for future growth. But the bond's income you get right away—and you know the old saying: ...