February 13, 2012 09:00 AM
By Tobias Levkovich, Chief U.S. Equity Strategist, Citi
This month's chart illustrates the earnings yield gap from November 1971-2011 and our analysis reveals powerful stock market gains with high probability outcomes. Various approaches to looking at stock market valuations over the past 40 years against risk free instruments all generate the same result -- a high probability (90%+) chance of double-digit equity market gains in the subsequent 12-month period. Such occurrences are rare but they are rewarding.
Cyclically adjusted earnings have removed the debate around peak earnings, while futures contracts on Treasuries do the same for potentially artificial immediate yield depressants. By looking at a P/E ratio on 10-year rolling average EPS, investors can better understand the earnings yield without having to modify valuation criteria around projected peak profit or margin arguments. Similarly, investors can use the five-year forward contract on 10-year Treasury yields to correct for near-term influences such as safe haven demand or current Fed policy.
The earnings yield gap of 10-year rolling EPS and the five-year forward yield look very compelling. At two to three standard deviations below its average since 1970, stocks have a 96% historical probability of forward 12-month market appreciation with historical median and average 20%+ gains. Hence, the view of the S&P 500 opportunity for 2012 remains very constructive, in our view.