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What does Stocks & Bond Yield Spread tell us?

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S&P 500 suffered from a huge loss in March, as the pandemic hit all over the world. Cheap stocks have attracted a huge buying from new individual investors. The prices of US Treasuries, on the other hand, were up due to Fed’s rate cuts in these difficult times. The US is now eyeing on normalizing everyday life, as the government cautiously lifts the lockdown step by step. S&P 500 in June showed strong rebounds and has returned to its pre-COVID level, are stocks cheaper or bonds cheaper? Stocks & Bond Yield Spread might offer some help & insight.


What is Stocks & Bond Yield Spread?

Stocks & Bond Yield Spread = Dividend or Earnings Yield - 2-year Bond Yield

Stocks & Bond Yield Spread is the result of dividend yield or earnings yield minus bond yield. The former reflects the costs of purchasing either stocks or bonds, helping investors find out whichever has a lower cost. The latter suggests whether now is the good time to increase your possession of stocks or bonds.


What is Dividend Yield?

Dividend Yield = Dividend / Price per share

Dividend yield reflects the least return one can receive by investing in stocks. When the Stock Dividend & Bond Yield Spread dives under zero, the stock market might be overheating, and investing in bonds is cheaper. It also suggests that the bullish cycle is ending and the risks in investing in stocks are increasing.

The Stock Dividend Yield & 2-year Bond Yield Spread back in 2018 was negative, as shown in the chart, and the US stocks were overvalued. A rational investor with limited funds would go for higher returns, and in that case of 2018, US bonds generate higher returns than the stocks.


What about Earnings Yield?

Earnings Yield = Eps / price per share.

Earnings yield is the inverse of P/E ratio. When the spread between earnings yield and 2-year bond yield widens, stocks can generate greater returns than bonds. While stocks generally make higher returns than bonds, they also incur higher risks. Whether or when you should shift your money from stocks to bonds depends on how much risks you can bear.


Summary

  • Earnings yield and bond yield spread showcases the profitability trend of the stocks and the bonds. When the spread closes, the rate of return on stocks drops. It is the investors’s choice to adjust the allocation of their portfolio.

  • Dividend yield and bond yield spread reflects the fundamentals of the stock market. When it gets negative, stocks are overvalued.

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