The Earnings Yield Gap

The earnings yield gap is a quick market valuation heuristic that compares the current earnings from the stock market against earnings from US Treasury bonds. The components are:

• Earnings Yield: This is the inverse of the price-to-earnings (P/E) ratio. It represents the earnings per share divided by the price per share and is expressed as a percentage. For example, if a company has earnings per share of $5 and its stock price is $100, the earnings yield is 5%.
• Government Bond Yield: This is the return on investment for holding a government bond, usually expressed as an annual percentage. Government bonds are considered a risk-free investment because they are backed by the government. Traditionally, a 10 Year bond is used when calculating the yield gap.
• Earnings Yield Gap: This is calculated by subtracting the government bond yield from the earnings yield of stocks.

When the earnings yield gap is highly positive, it suggests that stocks are relatively undervalued compared to bonds and may offer a better return, making them more attractive to investors.

As of May 31, 2024, the earnings yield gap is:

The current yield gap is shown in the chart below. The current value of -0.80% is 0.51 standard deviations below the historical average, indicating that stocks are currently Fairly Valued relative to bonds.

For a more detailed and illustrated explanation of the model, see below.

The earnings yield gap is a very simple comparison between the earnings yield of stocks versus bonds.

Stock Earnings

A stock's earnings yield is simple to calculate, it is just the inverse of the P/E ratio. That is, it is a calculation of how much profit the company made during the last year, divided by the company's stock price.

For example, as of this writing Alphabet (GOOG) has a price of $177.29 per share, and annualized earnings per share of $6.41. For each $177.29 you invest into Alphabet, the company generates accounting profit of $6.41. This is a P/E ratio of 27.64, and illustrates that it would take ~28 years for Alphabet to create profits equal to your investment. The earnings yield is the inverse of the P/E ratio, so here it would be $6.41/$177.29 = or ~3.6%. The simplified interpretation is that for every $100 you invest into Alphabet, the company generates $3.60 in annual profits that could theoretically be returned to you.

You can do the same exercise using aggregate data for the full stock market. For this model we use the S&P500 to approximate the full stock market. This isn't perfectly accurate - the S&P500 represents the 500 largest public companies, and only about 75% of the market cap of all public companies, but S&P prices and earnings are most redily available.

As of May 31, 2024, the current S&P500 earnings yield is 3.71%.

Treasury Earnings

This calculation is very simple since treasury bond yields are reported daily. If a treasury bond is at a 5% rate, that means for every $100 invested you'll receive $5 in earnings annually. This model uses the 10Y treasury bond since its neither short-term nor long-term, and is highly liquid. The 10-year yield aligns well with the investment horizon of many equity investors who are focused on medium to long-term returns.

As of May 31, 2024, the current 10-year treasury yield is 4.51%.

The chart below shows both the S&P500 earnings yield and the 10-year treasury yield since 1960. Note that they generally tend to move together, but in the short term there are some pretty large deviations between the two.

The chart below now shows the earnings yield gap, the spread between S&P500 earnings yield and the 10-year US Treasury rate. Positive spreads (shaded green) indicate that the earnings yield on stocks are higher than bonds, and that stocks are therefore relativly undervalued versus bonds.

As mentioned earlier, when stock yields are higher than bond yields it indicates that stocks are relatively undervalued compared to bonds. This is a very large generalization with a lot of nuance. There are many reasons that the earnings yield on stocks should generally be higher than that of bonds. In our model, the long term average gap between earnings yields on stocks and bonds is +0.28%. This is shown in the third chart, below, and provides more useful context about the current position relative to the average. Gaps smaller than this (higher, in the chart below) indicate stocks are relatively overvalued compared to bonds.

The last step to building the complete model is to show bands of standard deviations away from the average spread, just to get a better sense of how volatile the data is. This is shown in the chart below. As per our ratings guide, data points within +/- 1 standard deviation from the mean are considered fairly valued, and outliers beyond that range indicate markets of over/undervaluation. As of May 31, 2024, the current yield gap spread is 0.51 standard deviations below the historical average, indicating equities are Fairly Valued.

The below table cites all data and sources used in constructing the charts, or otherwise referred to, on this page.

Item	Source
SP500 Price	Yahoo! Finance S&P500 Daily Close Values
Historical Corporate Earnings	Publicly available S&P500 monthly data, aggregated and published by Robert Shiller at Yale;
Current Quarter Estimated Corporate Earnings	Estimates of current quarter SP500 aggregate earnings.
US Treasury Yields	U.S. Department of the Treasury - Daily Treasury Yield Curve Rates