Earnings Yield Gap

What Is the Earnings Yield Gap?

The earnings yield gap (EYG) is computed as the equity earnings yield — typically forward 12-month EPS divided by the current index price — minus the 10-year nominal government bond yield. A positive gap means equities offer a higher prospective yield than bonds, suggesting relative value in stocks; a negative gap implies bonds offer superior compensation per unit of expected return.

This framework is closely related to the Fed Model, a concept popularized by Ed Yardeni in the 1990s based on Federal Reserve research, which proposed that equity markets are fairly valued when the earnings yield equals the 10-year Treasury yield. The earnings yield gap operationalizes this framework into a spread that traders can monitor over time and across markets.

Note that the earnings yield uses forward earnings estimates, making it sensitive to the earnings revision cycle — a key source of signal contamination when analyst estimates are systematically biased.

Why It Matters for Traders

The EYG is one of the most widely used cross-asset valuation signals among institutional equity strategists and macro traders. It directly quantifies the equity risk premium on an earnings-based rather than dividend-based methodology, and it frames equity allocation decisions within the broader yield curve and monetary policy environment.

When the EYG is wide (equities offer significantly more yield than bonds), it historically supports equity overweights and risk-on positioning. When the gap collapses or inverts — as occurred in late 2022 and 2023 when rising real yields crushed equity valuations — it signals that the TINA (There Is No Alternative) trade is reversing, with capital rotating from equities to fixed income.

Multi-asset macro funds use EYG dynamics to time great rotation trades between equities and fixed income, particularly around major central bank pivots.

How to Read and Interpret It

For the S&P 500 versus the US 10-year Treasury:

• EYG > +200bp: Historically supportive of above-average forward equity returns; equities offer compelling relative value.
• EYG between 0 and +200bp: Neutral zone; allocation driven more by momentum, earnings trends, and financial conditions.
• EYG < 0 (negative gap): Rare historically pre-2022; suggests bonds offer better risk-adjusted returns. Sustained negative gaps typically correlate with equity multiple compression.

Always compare the EYG against its own historical range for a given market — European and Japanese equity EYGs have different baseline levels than the US due to structural differences in earnings yields and sovereign bond yields.

Historical Context

From 2009 through 2021, the US EYG averaged approximately +350 to +400 basis points, driven by ultra-low Treasury yields suppressed by quantitative easing. This wide gap provided the fundamental underpinning for the secular bull market narrative — equities were structurally cheap relative to bonds even at historically elevated P/E multiples.

In 2022, as the Fed raised rates from near-zero to over 5%, the 10-year Treasury yield surged from approximately 1.5% to 4.0%+. The S&P 500 forward earnings yield simultaneously compressed as prices fell. By early 2023, the EYG had narrowed to approximately +50 to +100bp — the tightest since the early 2000s dot-com era — fundamentally challenging the equity bull case and creating the most attractive bond entry point in 15 years.

Limitations and Caveats

The EYG's core weakness is its dependence on forward earnings estimates, which are systematically optimistic and subject to sharp earnings revision cycles. Using inflated forward EPS to compute earnings yield creates a false sense of equity cheapness. Additionally, the model breaks down in deflationary environments where bond yields are low due to weak growth rather than accommodation, as earnings expectations should also fall.

Academic critics note the Fed Model has no strong theoretical foundation, as it conflates nominal bond yields (which embed inflation) with real earnings yields (which are real economic flows).

What to Watch

Monitor the spread between S&P 500 forward earnings yield and the 10-year TIPS yield (real earnings yield gap) for a theoretically cleaner signal. Also track EYG dispersion across sectors and geographies — divergences between US, European, and emerging market EYGs often drive global sector rotation flows.