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.
How to Use the Earnings/Price Ratio
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?
Where U.S. Stocks Are Heading in 2012
One of the hallmarks of a bull market is a double digits earnings yield. Remember, the 2012 earnings yield is nearing double digits at 8.6%.
The last time theS&P 500 closed at a double-digit earnings yield on a monthly closing basis was November 30, 1984. If you bought stocks in 1984, you caught a ride on the biggest bull market in history.
Let's not forget the P/E ratio. Stocks look cheap by that metric, as well.
For the record, the average P/E ratio for the S&P since the 1870s has been about 15.
At the 1,290 level, the S&P 500 is currently trading at 11.5 times 2012 earnings. That's dirt-cheap.
Even at 13-times 2012 earnings, the S&P is worth 1,452.
Better yet, at a P/E of just 14.2, the S&P 500 would hit 1,586- crushing its old highs set back in 2007.
Anyway you look at it, two of the most important indicators are saying stocks are cheap as we start 2012 – especially with bond yields hovering at historic lows.
Of course, the great unknown in all of this is Europe. And admittedly it's a big one- but there's a good chance they'll eventually find a way to clean up the mess by printing up a few trillion euros in 2012.
The bottom line: 2012 is shaping up to be a great year for equities. You should have at least some exposure to U.S. stocks or risk missing a historic bull market run.
News & Related Story Links:
- Money Morning:
The Five Stocks You Have to Own in 2012
- U.S. News & World Report:
How to Value the Stock Market
Magic formula investing