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If you're a longtime investor, you're no doubt familiar with the Price/Earnings (P/E) ratio – a common measure for valuing the stock market.
But you may not be as familiar with the more-obscure Earnings/Price (E/P) ratio, which some experts refer to as the "earnings yield" on stocks.
If you're not familiar with the earnings yield, it's time to brush up.
While it may be obscure, the E/P ratio is an important tool. It not only tells you stocks' value, it allows you to compare that value to other assets like bonds.
And right now it's telling us a lot about buying U.S. stocks this year.
Basically, the risk/reward in favor of stocks over corporate bonds has never been this high…ever.
Let's take a look.
We can get a pretty good handle on the value of stocks if we look at the E/P ratio of the Standard & Poor's 500 Index.
In 2010, the earnings for the S&P 500 came in at $83.77. According to Standard & Poor's, the earnings estimates for 2011 are at $97.81 and will climb to $111.73 for 2012.
Taking the 2011 S&P 500 earnings estimate of $97.81 and the current S&P price of about 1,290, you come away with a multiple of 7.5% (97.81/1290). Simply put, this means that the expected earnings of the S&P 500 are 7.5% of the price of the index.
By the same token, if earnings come in at the expected $111.73 in 2012 and stock prices remain the same, the earnings yield jumps to 8.6%.
Why should you care? Because you want a higher rate of return for the risk of investing in stocks when compared to the rate of return of other asset classes.
Generally, the earnings yields of equities are higher than the yield of risk-free treasury bonds, reflecting the additional risk involved with stocks. But right now the difference is extreme, with 10-year government bonds yielding a paltry 2%. Meanwhile, corporate bonds are paying about 5%.
Now let's compare the return on stocks to the rate of inflation.
Over the past 50 years, the average earnings yield for the S&P 500 has outpaced inflation by 2.4%. When the market is above that mark, equities are considered attractive. When it's below, they're expensive.
Subtract the current core inflation rate of 1.5% from the 2011 S&P 500 earnings estimate of 7.5%, and we end up with 6% – well above the 50-year average. Even if we use the 3.4% consumer price index rate, you're left with a difference of 4.1%. Compare that to bond yields and you're still way ahead.
So that's where we are, but how about where we're headed?