Above the noise: Earnings fear is approaching a 54-year high!

A month ago I showed how the earnings and dividend to US 10 year government bonds yield spread had widened to levels not seen since 1975 (see chart below). It clearly shows the insanity spreading like a cancer throughout our entire financial system.

Today, with inspiration from A Dash of Insight and Dr. Ed Yardeni, I will show how the earnings to corporate bond  (Moody's BAA corporate bonds index) yield spread has widened to an almost 54 years high (see chart below). The yield spread is based on the trailing earnings yield of S&P 500 and the Moody's BAA corporate bond yield.

The yield spread is a thermometer measuring investors' earnings fear, which makes sense in the current environment, but the recent moves in financial assets raises the question of whether investors have completely overshot this time. According to Jeff Miller, A Dash of Insight, the S&P 500 has to rise 27 percent to close the gap! This of course assumes unchanged levels in corporate bonds in a stock rally, which may be too narrow an assumption. As the chart also shows, equities normally trade at a lower yield compared to corporate bonds to reflect the higher risk and return profile. If that relationship was to be restored over the next year, S&P 500 would have to go up a lot regardsless.

If mean reversion is one of the iron laws of economics and financial markets (except for the times when things do not mean revert, see: Enron) then you would expect equities to perform quite well over the next couple of years relative to bonds. But that assumes Europe heals, China can engineer an economic transition and the US returns to trend growth. All that seems very distant right now. But at some point you have to bet some of the farm to get some decent return. Bonds cannot give you that anymore unless you leverage your positions several times.