Where the rubber meets the road imageMoney goes where money grows. In all cases investors, driven by the emotions of fear and greed, will put their money where they believe it will do the most good. Those seeking capital appreciation buy stocks in spite of the risks involved and those seeking capital preservation buy bonds in spite of low returns.

In the absence of fear and greed, the Earnings Yield of stocks, EY, would equal the Interest Yield, IY, of long-term bonds, i.e., EY = IY, where
EY = 100*(Earnings per share/Stock Price), and IY = 100*(Interest Payment/Bond Price).

Given the presence of fear and greed, EY typically does not equal IY. When greed dominates investor psyche, stock prices are high and EY is low. When fear dominates investor psyche, bond prices are high and IY is low. Currently, the average forecasted EY of stocks in the S&P500 is 5.16%, which is about 14% less than the 20-year average of 6%. The current long-term IY of AAA corporate bonds is 2.99%, which is about 50% below the 20-year average of 6%. Since IY is so much below its long-term average, fear continues to dominate investor psyche as it has since the financial crash of 2008.

In order to be compensated for the perceived risks of buying stocks instead of bonds, investors demand an Earnings Yield premium compared to the Interest Yield of bonds. This Yield Premium, YP, is currently equal to EY – IY = 5.16 – 2.99 = 2.17%. Why is this important?

Following the crash of 2008, the Federal Reserve has maintained a policy of extremely low interest rates to stimulate the economy and avoid deflation. Should the current Head of the Federal Reserve, Ms. Janet Yellen, raise the Federal Funds rate as she hopes to do, it could squeeze the Yield Premium by causing EY to go lower or IY to go higher. In either case, stock prices would have to fall in order to restore YP to its original level. It’s Where the Rubber Meets the Road.