What is the Earnings Yield Gap
The earnings yield gap is the difference between the earning yields and the long-term Treasury yield. The earning yield gap reflects how stocks are overpriced or underpriced compared to the government bond yield which is a risk-free investment.
Normally, an investor uses the earnings yield gap (EYG) to determine which investment is more attractive, between stocks and government bonds (risk investment vs safe investment).
The higher earnings yield gap means the gap between the yield of the stock and government bonds is larger. As a result, investors tend to invest in the stock market due to the stock returns.
In contrast, the lower earnings yield gap means the gap between the earnings yield and government bonds will be smaller. In other words, the difference between the returns on stock and government bonds is small. As a result, investors tend to invest in government bonds rather than stocks.
How to Calculate the Earnings Yield Gap
The earnings yield gap can be calculated by deducting the earnings yield with the long-term Treasury bond yield (10-y Treasury yield).
Earnings yield gap = Earning yield – Treasury yield
Note: You can follow the 10 year U.S. Treasury yield on U.S. Department of Treasury website.
For example, the U.S. stock market yield is 2.5%, while 10 years Treasury yield is 1.5%. The earnings yield will be 2.5 – 1.5 = 1%.
What does it Indicate?
The purpose of calculating the earning yield gap is to assess whether the equity is overpriced or underpriced as compared to government bonds:
A large number of the earnings yield gap (returns on stocks > Treasury bonds) means the difference between the stock market and government bonds is large. In other words, the stocks are cheap or underpriced.
As a result, investors tend to allocate their investment to stocks (or related risky investments) to find more yield.
A small number of the earnings yield gap (returns on stocks < Treasury bonds) means the difference between the stock market and government bonds is small. In other words, there is no difference between investing in the stocks market and the bonds market, while the stock is higher risk than the bonds.
As a result, investors tend to allocate their investment from risky investment into lower risk and risk-free investment like government bonds.
For your information, the earnings yield gap is also known as: the yield gap, yield ratio, and bond equity earnings yield ratio (BEER).
