A "Go" Signal for Equity Outperformance

Given the skimpy yields on bonds, the opportunity in equities has rarely been more provocative, at least according to one fairly reliable indicator, as my colleague Gerry Paul ably argues below.

Assessing the Opportunity Cost

Despite the recent rally, investors remain wary of equities. For many, stock valuations, while attractive versus history, still don’t seem compelling enough to compensate for the extreme uncertainties in the world today. But investing is also about comparative opportunity cost. From that perspective, one fairly predictive metric we follow suggests that the opportunity in equities has rarely been as provocative as it is now. I’m talking about the yawning gap between the stock market’s earnings yield (the reciprocal of its price/earnings multiple) and long-dated government bond yields.

Our “yield gap” compares an inflation-adjusted earnings yield (based on 10-year average trailing earnings, to normalize business-cycle gyrations) to the nominal yield on 10-year government bonds. At the end of 2011, the earnings yield for the aggregate of S&P 500 companies was 4.8%, meaning that earnings accounted for 4.8% of the market’s value. Versus the 2% Treasury yield, the yield gap was 2.7%, which was below the 4.7% peak at the 2009 market bottom, but well above the historical median of 0%, as you can see in the Display below.    

The yield gap can tell us a lot about the future performance of equities versus bonds. Looking at data going back to World War II, we found a very strong correlation—90%—between movements in the yield gap and the 10-year forward performance of equities versus Treasuries.

We also studied the frequency of equity outperformance versus Treasuries in rolling forward one-, three-, five- and 10-year intervals since 1946, generally and when the yield gap was above zero at the beginning of the period studied. In both cases, stocks beat bonds more often as the time periods lengthened, as seen in the Display below. The S&P 500 beat 10-year Treasuries in about 87% of all 10-year periods. But it outperformed in 99% of the 10-year periods that started with the yield gap above zero.

The Oddas Are in Equity's Favor

This historical analysis says nothing about near-term timing, and the past is not necessarily prologue. But with the US Federal Reserve promising to keep interest rates at current ultralow levels through at least 2014, we think that today’s unusually wide yield gap makes a persuasive case for an equity-market comeback. As I've written before, we get a similar reading from another key gauge, the equity risk premium, which at 8.2% at year end suggests that investor fear of equities is at a 50-year—and, in our view, unsustainable—high.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

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Sharon E. Fay, CFA

Head and Chief Investment Officer—Equities
Sharon E. Fay was named Head and Chief Investment Officer of Equities in July 2010. She is responsible for overseeing AB’s portfolio management and research activities relating to all equity investment portfolios. Previously, Fay served as CIO of Global Value Equities from 2003 to 2014. From 1999 to 2006, she was CIO of European and UK Value Equities, serving as co-CIO from 2003 to 2006 after being named CIO of Global Value Equities in 2003. From 1997 to 1999, Fay was CIO of Canadian Value Equities. Prior to that, she had been a senior portfolio manager of International Value Equities since 1995. Fay joined the firm in 1990 as a research analyst, subsequently launching Canadian Value, the firm’s first single-market service focused outside the US. She then went on to launch the company’s UK and European Equity services and build Bernstein’s London office, home of its first portfolio management and research team based outside the US. Fay holds a BA from Brown University and an MBA from Harvard Business School. She is a CFA charterholder. Location: New York

Joseph Gerard Paul

Chief Investment Officer—Strategic Equities and US Value Equities
Joseph Gerard Paul serves as Chief Investment Officer for Strategic Equities, appointed in 2014, and US Value Equities, appointed in 2009. He has also served as CIO of the Advanced Value Fund since 1999. Paul was previously CIO of Small & Mid-Cap Value (2002–2008) and co-CIO of Real Estate Investments (2004–2008). Additionally, he was the director of research for the Advanced Value Fund for two years. In that role, Paul was instrumental in the genesis of the Advanced Value leveraged hedge fund. He joined Bernstein in 1987 as a research analyst covering the automotive industry, and was named to the Institutional Investor All-America Research Team every year from 1991 through 1996. Before joining the firm, Paul worked at General Motors in marketing and product planning. He holds a BS from the University of Arizona and an MS from the Massachusetts Institute of Technology’s Sloan School of Management. Location: New York

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