The Shrinking Advantage of Stock Ownership Compared to Bonds Sparks Concerns of Unsustainability as a Key Measure of Stock Value Hits a Two-Decade Low.
The extra reward for holding stocks instead of bonds has fallen to its lowest level in 20 years, threatening a recent hot streak for major indexes.
One method for gauging the value of stocks is to compare their earnings yield—calculated by dividing a company’s expected earnings over the next year by its stock price—to the yield on government bonds, considered the closest thing to a risk-free return. The difference, sometimes called the equity-risk premium, shows how much investors are being compensated for the additional risk of owning stocks.
And right now, that isn’t much.
The gap between the earnings yield of the S&P 500 and the yield on the 10-year U.S. government bond dropped to around 1.1 percentage point last week. This is the narrowest since 2002. The spread to the yield on the 10-year Treasury inflation-protected security (TIPS), seen by some analysts as the better benchmark because corporate earnings tend to adjust with inflation, has similarly fallen to its lowest level since 2003, at around 3.5 percentage points.
The risk premium first started shrinking in the second half of last year. In that period, stocks stabilized from an early year selloff, even as bond yields continued to climb in response to the US Central Banks raising interest rates to fight inflation. This year, the premium has continued to dwindle for slightly different reasons: Bond yields haven’t risen as much, but stocks have taken off - lifted by investors’ increasing optimism about the economy.
S&P 500 one–year forward earnings, yield minus yield on 10–year Treasury, inflation, protected, security.
Source: Factset (S&P 500): trade web (TIPS yield)
Whatever happens, to change it, there is a consensus on Wall Street that the equity-risk premium can’t stay this low forever. For stock prices relative to earnings to be back to where they were at the start of the 2022 selloff “when interest rates are 2x, 3x higher than they were really doesn’t add up,” said Tim Urbanowicz, head of research and investment strategy at Innovator ETFs. However, investors and analysts tend to agree that an ultralow risk premium doesn’t mean that this year’s stock rally has reached its conclusion.
For one thing, they point out, risk premiums have gotten much lower before—in the dot-com bubble of the late 1990s. Back then, the gap between the S&P 500’s earnings yield and inflation-adjusted, or “real,” Treasury yields briefly collapsed entirely, according to some measures. Looking back at history, analysts say risk premiums revert to average over time—typically because prospects for corporate earnings dim, not because investors get frightened by valuations on their own.
“I haven’t found a very strong statistical relationship between the earnings yield relative to the 10-year Treasury—whether it’s real or nominal—and future returns over, say, a one- or three-year horizon,”
Brian Jacobsen, chief economist of Annex Wealth Management.
Investors have another source of hope: Risk premiums could normalize because bond yields fall rather than stock prices. Stoking this optimism, many believe that the Fed is finally done raising short-term interest rates. With inflation showing signs of cooling, interest-rate futures indicate that traders largely believe the Federal Reserve might pause its rate-setting policy. According to the CME FedWatch Tool, the probability of a pause stood at 97% after the data were released, which showed the consumer price index rose 0.6% in August, its biggest monthly gain of 2023.
Last month, Federal Reserve Chair Jerome Powell said inflation remained too high, claiming central bankers were prepared to tighten policy further if necessary. However, investors are uncertain about the likelihood of another hike. They believe the Fed will leave rates unchanged at its September 19-20 policy meeting. The futures market also indicates a lower chance of an increase in November. Rubeela Farooqi, chief US economist at High Frequency Economics, said:
“These data are supportive of a pause in September. However, the FOMC is not likely to declare victory until it sees further evidence of improvement towards the 2% target. They will remain open to further rate hikes if needed.”
Yields on U.S. Treasurys largely reflect investors’ expectations for short-term rates over the life of a bond. Even if the Fed has reached the end of its tightening campaign, bond yields could rise further if the central bank keeps rates at current levels for longer than investors anticipate. Still, the consensus is that both rates and bond yields should eventually decline.
Meanwhile, most Fed officials estimated in August that real interest rates (nominal interest rate minus inflation rate) will eventually settle at a level no higher than 0.5%. Jacobsen, of Annex Wealth Management, said he thinks the 10-year TIPS yield could fall to 0.75% or 1% over the next 12 to 18 months (it is currently at 1.95%). That would mean investors are rewarded more for owning stocks, assuming indexes don’t rally much further. But it would also mean that bond prices have climbed. Jacobsen said his team has recently recommended that clients move more money into bonds after previously tilting more heavily toward stocks.
