Saturday, August 20, 2011

Looking for Reasons to be Bullish

It's never easy to be bullish in an environment like this one, but in attempt to not get too bearish, it's always important to be on the lookout for bullish signals.

One such signal is a comparison of the forward earnings yield of the S&P 500 to the 10 year treasury yield.  The two have diverged significantly in the last couple weeks.  In fact, the forward earnings yield of the S&P 500 based on current year earnings estimates is almost back to where it was in '09.  The spread between the two measures is higher than it was in '09.

Many will quite logically argue that the forward earnings yield is irrelevant because earnings estimates will be revised downward.  While this may be true, the historical spread between the earnings yield of the S&P 500 and the 10 year treasury is in the 2-3% range.  Today, this implies that an earnings yield of 4-5% on the S&P is fair value.  In other words, at this level, earnings on the S&P 500 could be revised down by about 50% to $50 and equities would still not be expensive relative to bonds on a historical basis.

Another indicator acting favorably compared to equities are credit spreads, which don't appear to be quite as concerned about companies' earnings power as equities are.  While equity yields trade back to 2009 levels, credit is still significantly better off than it was in '09.

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