Alternative Yield Discount (Inflation) Rates

April 12, 2012 • Posted in Economic Indicators

Investors arguably expect that holdings earn profits in excess of the inflation rate. Do different measures of the inflation rate indicate materially different investment yield discounts? To investigate, we consider how the following two pairs of lagged annual inflation rates related to the S&P 500 annual operating earnings yield (E/P, lagged from Standard & Poor’s and forward from the Earnings Forecast), the S&P 500 annual dividend yield (lagged from Standard and Poor’s) and the 10-year Treasury note (T-note) and 3-month Treasury bill (T-bill) annualized yields:

  1. The non-seasonally adjusted inflation rate based on the total Consumer Price Index (CPI) from the Bureau of Labor Statistics (retroactive revisions of seasonally-adjusted data confound historical analysis).
  2. The non-seasonally adjusted inflation rate based on core CPI from the Bureau of Labor Statistics.
  3. The inflation rate based on the Personal Consumption Expenditures: Chain-type Price Index (PCEPI) from the Federal Reserve Bank of St. Louis.
  4. The trimmed mean PCE inflation rate from the Federal Reserve Bank of Dallas.

Using monthly data for all variables during March 1989 through February 2012 (23 years), we find that…

The following chart tracks the four annual inflation rates, S&P 500 forward annual E/P and T-note annualized yield over the sample period. Results suggest that:

  • Inflation rates based on CPI and PCEPI behave similarly, with the former generally higher.
  • Inflation rates based on core CPI and trimmed mean PCE behave similarly, with neither consistently higher.
  • As designed, inflation rates based on core CPI and trimmed mean PCE are much less volatile than those based on CPI and PCEPI.
  • S&P 500 forward E/P is almost always higher than the inflation rates, with gap size varying but not systematically. The gap is currently wide, suggesting an expectation of an increasing inflation rate (or decreasing earnings).
  • T-note yield is mostly higher than the inflation rates, with gap size mostly shrinking over the sample period, suggesting an expectation of a decreasing inflation rate.

Over the entire sample period, average annual inflation rates based on CPI, core CPI, PCEPI and trimmed mean PCE are 2.93%, 2.78%, 2.50% and 2.50%, respectively. Average annual S&P 500 lagged dividend yield, lagged E/P and forward E/P are 2.14%, 5.43% and 5.56%, respectively. The average annualized T-note yield is 5.37%.

What are the series correlations?

The following table summarizes correlations between inflation rate and investment yield pairs over the available sample period. Results suggest that:

  • S&P 500 E/P metrics relate more strongly to the overall inflation rate than to a core/trimmed rate.
  • S&P 500 lagged E/P relates more strongly to lagged inflation rates than does S&P 500 forward E/P.
  • Treasury yields relate more strongly to a core/trimmed inflation rate than to an overall rate.
  • S&P 500 E/P metrics relate hardly at all to Treasury yields.

So, what are the average annual investment yield premiums over the inflation rates?

The following three charts summarize the average annual S&P 500 lagged and forward E/P and the T-note premiums over the four inflation rates for the available sample period. Premiums are in the range 2.4% to 3.1%. There is hardly any difference between the average premiums for equity operating earnings yield and the T-note yield (but the latter shrinks over the sample period).

The S&P 500 dividend yield carries negative premiums to all four inflation rates. Since the mid-1980s, stock buybacks substantially displace cash dividends.

In summary, evidence suggests that investors require a real annual yield in the range 2.4% to 3.1% from both stocks (based on operating earnings) and T-notes over the past 23 years, with stocks relating more strongly to total inflation rates and T-notes to core/trimmed inflation rates.

Cautions regarding findings include:

  • Sample size (limited by availability of S&P 500 operating earnings data) is fairly small relative to 12-month calculation intervals.
  • There is a delay of about a half month in release of inflation rate data relative to the end of the month measured.

See the Real Earnings Yield Model for concept extension.

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