Trillion-Dollar Earnings Yield Keeping S&P 500 Out of Fed Reach

(Bloomberg) -- If we’ve learned anything after 21 months of Federal Reserve tightening, it’s that $1 trillion a year in corporate earnings provides the S&P 500 with a daunting buffer.

How else to explain the stock market’s ability to whistle past four interest rate hikes and climb to records, a feat that may come up at this week’s meetings in Jackson Hole, Wyoming? Central bankers tighten, political tension escalates, valuations swell -- and the market skates along on one of the sturdiest foundations of profit ever amassed.

This isn’t how investors thought it would play out -- at least not two years ago, when concern about the withdrawal of stimulus sent the S&P 500 buckling into two separate 10 percent corrections. Now the Fed funds rate is actually climbing, and stocks are almost 20 percent higher than they were then.

The explanation is profits, whose ability to jump 10 percent a quarter is providing a steady stream of cash flow to companies and drowning out the appeal of other asset classes. Fattened by the central bank’s own largess, the earnings yield of the S&P 500 still far surpasses the payout in the bond market, with the gap between the two near the highest level this year. 

There’s a 2.6 percentage point difference between S&P 500 income expressed as a percentage of price -- right now 4.8 percent -- and the 10-year Treasury yield of 2.2 percent. The same case can be made for equity dividends, with more than 200 companies offering higher payouts than the bond market.

Bond yields have a long way to go before they start to detract from the appeal of equities, according to Connor Browne, a portfolio manager at Thornburg Investment Management in Santa Fe. Browne sees a yield “closer to 5 percent” on the U.S. 10-year as a level at which investors may leave stocks for bonds.

“If you think about the future generation of cash flow in stocks you don’t have to discount it back that much because interest rates are so low,” Browne said by phone. High earnings and dividend yields “are really important. It’s hard to figure out where else to go.”

Balance-Sheet Threat

Languid bond yields are softening the impact of tighter policy, with the 10-year Treasury unmoved since 2015. Together they make the most believable case for S&P 500 price-to-earnings ratios that rival anything since the dot-com bust.

“It’s been a combination of things,” Chris Harvey, head of equity strategy at Wells Fargo, said by phone. “Too many dollars chasing too few assets, increased transparency by the Fed, the stability of GDP and an improvement in fundamentals as we went form earnings contraction to improvement and growth.”

Stock market resilience is rooted in improving financial market conditions, Harvey says. Despite the Fed’s hikes, persistently low 10-year rates and tightening investment grade credit spreads have been supportive of equity prices, he wrote in a note to clients earlier this month.

That doesn’t mean it’s going to be entirely smooth sailing from here on out. In addition to more rate increases, the next item on the Fed’s agenda is the unwind of their $4.5 trillion balance sheet.

Adding that balance-sheet unwind to the equation could pose a greater threat to stocks than the initial string of rate hikes, according to Alex Bellefleur, head of global macro research and strategy for Pavilion Global Markets Ltd in Montreal.

“I’m a little skeptical that the tightening will go super well as far as asset prices go,” Bellefleur said in a phone interview. “The late stages of tightening can be more damaging than the early stages.”

To contact the reporter on this story: Oliver Renick in New York at orenick2@bloomberg.net.

To contact the editors responsible for this story: Arie Shapira at ashapira3@bloomberg.net, Chris Nagi, Richard Richtmyer