BEER: Beguiling or Busted Signal?

Based on the view that government bonds and stocks are regarded as competing assets by investors, a model has developed to extract the information content inherent in the relationship between bond yields and equity yields.  The ratio of Bond Yield to Equity Yield (BEER ratio or BEYR ratio) provides a measure of perceived risk in the bond market versus the stock market.  It has become a popular means to indicate how much the equity markets are expensive or cheap relative to bond markets. 

How it Works

Whenever the equity yield has crossed above the bond yield, it implies that even with no earnings growth, equity will deliver better returns than debt.   The ratio less than 1.00 can be a harbinger of the bottom of the equity market.  Conversely, when equity yields are lower than bond yields, it suggests equities are expensive relative to bonds.  A ratio greater than 1.00 is a call to caution for equity investors.

The current S&P 500 earnings yield is 3.79%.  This level is well above the historic low equity yield of 0.81% established in 2009 at the onset of the Great Recession, but still not above the historic average.  The current ten-year treasury rate of 2.47% is the near all-time historic low.  The Bond Equity Earnings Yield ratio is currently 0.65 (2.47% / 3.79%  =  0.65), suggesting equities are attractive.  

Using BEER

Before traders race off to acquire cheap equities, it is important to consider alternative explanations for the relative levels of equity and bond yields.  For example, a ratio less than 1.0 could also be triggered by mispriced bond yields.  What if the current bond market is not adequately pricing risk?  The U.S. bond market has come through an exceptional period, during which the Federal Reserve engaged in unprecedented stimulus and continuously suppressed interest rate levels.  It is not entirely clear that bond prices accurately reflect the supply implications of the Fed’s ongoing balance sheet divestiture plan.  With another ‘bond shoe’ yet to drop, it is questionable whether the BEER ratio is sufficiently reliable to inform an investment strategy in the U.S. market. 

Another study completed by the Leuthold Group, a financial research firm, found that the BEER ratio had no predictive value.  The study was based on equity returns in the U.S. stock market during the period between 1878 and 2013.  However, the study also determined that when Treasury yields rise above 6% there is some value in watching the BEER ratio. 

Apparently, at higher bond yields investors have a different perception of the merits of debt investing.  Otherwise bonds and stocks are viewed as separate assets classes and investors only make an allocation choice between bonds or stocks.  Thus the BEER or BEYR ratio may have more value for entertainment than informing investment decisions in the U.S. equity market.

Europe’s Story

A different conclusion was reached by a study of certain markets in Europe.  A study was completed by Sweden’s Umea School of Business and Economics based on bond and equity yields in Denmark, Finland, Norway and Sweden.  During the observation period between 1973 and 2014, following a BEYR strategy would have led to excess return over the market portfolio in all four markets.  Additionally, the BEYR portfolios had greater Sharpe ratios than those of the market portfolio, indicating better risk adjusted returns and thus a sounder relationship between risk and return.  Yet these results were not statistically significant and only hint at potentially positive results from using a BEYR approach. 

Fundamental Picks, Technical Trades

Despite the beguiling results of the current Bond Equity Yield Ratio, it is more or less a busted signal for equity investors.  A weak signal to begin with, there is good reason why the BEER ratio is even less informative than ever based on today’s bond market.  Small-cap investors in particular will need other strategies to underpin their investment decisions.  At the end of the day, it may just be thorough fundamental analysis to choose strong companies followed by artful technical analysis to make astute trading decisions.