Last Updated on 7 April, 2022 by Samuelsson
Seasoned investors know that inflation affects equity returns, but what is the nature of the relationship between them? How do changes in CPI affect the S&P earnings yield?
Generally, when inflation is low, earnings and earnings yield are low. On the other hand, when inflation is high, earnings increase and so does earnings yield. However, the relationship is a bit complicated; sometimes, the worst returns are made during periods of extremely high inflation.
In this post, we will explain what S&P earnings yield mean, explain inflation and CPI, discuss the relationship between earnings yield and CPI, and finally, analyze the relationship with some data and chart.
Earnings yield explanation: what does S&P earnings yield mean?
Earnings yield is mostly seen as a return metric, rather than a valuation metric like the P/E ratio, but being an inverse of the P/E ratio, some investors occasionally use it for valuation purposes too.
It is used to determine optimal asset allocations by considering the yields of the various assets. The metric may also be used to estimate value: that is, whether the asset is overpriced or underpriced. A low earnings yield indicates a potentially overpriced asset, while a high earnings yield indicates a potentially underpriced asset. In other words, an overvalued investment can lower earnings yield, and an undervalued investment can raise earnings yield. The reason is that the higher the stock price goes without a comparable rise in earnings, the lower the earnings yield will drop, while if the stock price falls, but earnings stay the same or rise, the earnings yield will increase.
With regard to the S&P 500 Index, which represents the 500 biggest stocks in the US stock market, earnings yield is a measure of the rate of return of the US stock market. Thus, this earnings yield is more of a return metric revealing how much an investment in an S&P ETF may earn for investors, rather than a valuation metric showing how investors value the investment.
Understanding inflation and CPI
Inflation is when the purchasing power of a currency declines over time, which manifests as an increase in the level of prices of the goods and services that households buy. In situations where the prices fall, it is called deflation. Inflation/deflation is measured as the rate of change in the prices of consumer goods.
The most well-known indicator of inflation is the Consumer Price Index (CPI), which estimates the percentage change in the price of a basket of goods and services consumed by households. It examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care, and gets the average of the price changes for each item in the predetermined basket of goods. Changes in the CPI are used to assess price changes associated with the cost of living.
While the CPI is one of the most frequently used statistics for identifying periods of inflation or deflation, there are others, such as the producer price index (PPI), which instead of considering prices paid by consumers looks at what businesses pay for inputs. The CPI statistics cover a variety of individuals with different incomes, including retirees. However, it does not include certain populations, such as patients of mental hospitals.
In the US, the Bureau of Labor Statistics (BLS) reports the CPI on a monthly basis and has calculated it as far back as 1913. The index is based upon the index average for the period from 1982 through 1984 (inclusive), which was set to 100 as the standard. Thus, a CPI reading of 100 means that inflation is back to the level that it was in 1984, while readings of 175 and 225 would indicate a rise in the inflation level of 75% and 125% respectively. Note that the quoted inflation rate is actually the change in the index from the prior period, which can be monthly, quarterly, or yearly.
The relationship between the S&P earnings yield and CPI
Generally, S&P earnings yield positively correlates with the CPI: when inflation is low, earnings and earnings yield are low. On the other hand, when inflation is high, earnings increase and so does earnings yield. However, the relationship is a bit complicated; sometimes, the worst returns are made during periods of extremely high inflation.
S&P Earnings Yield vs. CPI YOY Spread Mode Regression Analysis Summary Table
|Bin#||Level||% of Time||2-year Return|
|1||6.16 =< Level <= 8.92||5.41%||31.59%|
|2||3.40 =< Level < 6.16||36.29%||21.29%|
|3||0.64 =< Level < 3.40||47.72%||15.97%|
|4||-2.12 =< Level < 0.64||10.58%||2.46%|
From the table above, you can see that the higher the inflation, the bigger the returns. With a good strategy, you can exploit conditions of rising inflations to make money. See the chart below: