Citi’s Tobias Levkovich has become a bit sceptical of this rally, but overall he’s still quite bullish on where stocks might head.
One reason for that? The spread between the S&P 500 earnings yield vs. the 10-year Treasury rate.
The basic idea is that if you imagine that stocks could theoretically pay out 100% of their earnings as dividends, you can easily compare stocks to bonds based on yield. If the S&P had an average PE of 20, then you could say that you’re getting a 5% earnings yield. If bonds were only paying 1%, then you’re obviously getting way more meat buying equities, with a fat 4% spread between them.
Anyway, it turns out that using this method shows that stocks are still incredibly cheap, even after their runup.
In the chart below, Levkovich is using the S&P 500 10-year rolling earnings (so it includes the earnings collapse of 2008/2009), and comparing that to the yield on the 10-year, which remains remarkably low, as we’ve been pointing out all year.
The gap is currently between 2 and 3 standard deviations away from the average (going back tio 1971), and based on this, the average 12-month gain from here is a stunning 24.0% for equities, according to Levkovich.
You can see the value in this technique. In 1999, when stocks were near a peak, the spread was exactly the opposite, as investors were getting FAR more yield from risk-free Treasuries than they were from equities.
Bottom line today: Even with the runup, and some yellow warning signs, the outlook is extremely bullish.