US Equities earnings yields are the inverse of the more popular measure “price-to-earnings ratio”. However, yields are more intuitive to understand and more accessible to compare. For example, if we assume that equities earnings don’t grow, the earnings yield would represent the yield an investor will receive if a company’s net income is 100% distributed to holders of the equity security. This makes it much easier to compare to bond yields since bond coupon payments don’t grow and are fully allocated to holders of the bond. Of course, equity earnings grow, and the income is never 100% distributed.

When we look at the data, we observe that equity and bond yields can be broken down into two distinctive periods, pre-1970 and post-1970. As you can see from the chart, there appears to be a positive relationship between US 10Y Treasury yields and US Equity yields after 1970.

Using Pearson correlations, we can see that the relationship was, on average, negative between the 1930s and 1960s and generally positive since the late 1960s. We can only speculate on what caused the negative correlation. One explanation is the Bretton Woods currency system. The system was intended to govern monetary relations among countries. The Bretton Woods System required a currency peg to the U.S. dollar, which was pegged to the price of gold.  The system of currency convertibility that emerged from Bretton Woods lasted until 1971 when US President Richard Nixon announced the suspension of the dollar’s convertibility to gold. However, the system showed signs of cracks before its official end. However, there could be other explanations, such as WWII, expansionary monetary policy following the Great Depression, changes in regulation and taxation, etc. Nonetheless, the 10-year rolling correlation between equities and treasury yields reinforces the probability of a structural change.

It is also worth noting that the 10-year rolling correlations declined between 2009 and 2018. From the chart below, we can tell that earnings yield increased following the dot-com bubble (2001- 2007), while bond yields were relatively stable. Similarly, earnings yields exploded higher after the 2007-2009 Financial Crisis. This volatility decreased the 10-year rolling correlation during that particular period. Even so, the general relationship between equity and bond yields resumed after 2010.

There are two variables in the earnings yields: price and earnings (net income). Therefore, the earnings yield can go down in two ways: either net income is lower (earnings compression) or prices move higher (multiple expansion). The reverse would be increasing yields, net income moving higher (earnings expansion), or prices moving lower (multiple compression). The two variables don’t always move together. Since 1970, multiple expansion has dominated earnings expansions, however, that’s not true for all subperiods.

For example, during the interest-rising environment in the 1970s and early 1980s, earnings grew at a higher rate while multiples compressed or stayed the same. Specifically, between 1972 and 1982, the S&P 500’s price return was only 1.60%, while the total return was 6.20%. Returns during the period were primarily driven by earnings growth, which translated into dividends.

The reverse is true of the declining interest rate environment between 1982 and 2021. During these 40 years, price appreciation was the dominant driver. Hence, we see the higher average P/E ratios during the period.

Theoretically, it makes sense that bond yields and equity earning yields are correlated since the two investments compete for investors’ capital. If investors believe that earning yields are too low, they can easily switch to bonds, given their income yield is more attractive, and vice versa.  Further, the stock price is the discounted present value of future cash flows, and interest rates typically determine the discount rate. The higher the interest rates, the higher the discount rate, the lower the valuation.