The spread between the S&P 500 earnings yield and the 10 yr. Treasury remains near an unprecedented high – is mean reversion on the way and what does that imply? . . .

The following note is a refresh of the chart I have presented in the past here, and the post I made in August here.  The chart below displays the 10 year Treasury rate vs. the S&P 500 earnings yield and a histogram of the spread between the two.  In modern market history there was only one time when the spread was as lopsided – Sept. 1974.  The notion of “reversion to the mean” suggests that something has to give . . . Treasury rates will have to rise, earnings for the S&P 500 will have to fall or stock prices will have to rise – by a lot.  In 1974 inflation was rising, the Yen devalued, Nixon resigned as President and we were in recession.  Following the peak in the spread in Sept. ’74, the S&P 500 gained 7.9% in Q4 and 21.6% in Q1 1975.  The 10 yr. rate was stable and rose to 7.7% in Q1 1975.  S&P 500 earnings actually declined sequentially in each of Q3 74, Q4 74 and Q1 75 so near term rising earnings was not a predicate for rising stock prices.  The S&P 500 went on to rise over 30% in 1975 as the 10 year rate hovered in the 8% area.  As I said in August . . . Anyone who believes in reversion to the mean should be wildly bullish.  Returning the spread to where it was at Dec. 2010 would imply a gain on the S&P 500 of ~50%.  Conversely it would imply a rate on the 10 yr. of ~4.5%.  Each of those implications seem extreme.  A “meet in the middle” can support a gain of 25% for the S&P 500 in 2012.  Jeb Terry, Sr. January 2, 2012

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