The divide between the earnings yield for the S&P 500 and 10-year Treasurys is at its narrowest since Fall 2007—1.59%, according to an article in The Wall Street Journal. The low equity risk premium makes stocks look less appealing than bonds, and they need to be able to offer a higher return than bonds for the long term in order to retain investors who will eventually jump ship to Treasurys.
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With lowered expectations for corporate earnings and rising bond yields, stocks have become less and less attractive. That puts the Fed in a tight spot as it tries to cool inflation by raising rates and also prevent a crisis in the banking sector—two actions that put a damper on stocks. So far in 2023, the S&P 500 has gained back 6.9% from its 19% loss last year while the Bloomberg U.S. Aggregate Bond index has shot up 4.2%. Elevated bond yields present a “once in a generation opportunity,” Tony Despirito of BlackRock Inc. told The Journal. His firm’s research shows that the average equity risk premium over the long term is about 1.62 points—not that far off the current level. Given that track record, stocks should still maintain their edge over bonds, the article reports.
In October 2007, stocks had just reached record-high prices while the bond yields were at 4.8%—near the current level. Over the next 12 months, the S&P 500 dropped 45%, the Fed slashed rates down to next-to-nothing, and valuations evened out while bond yields plunged. After stocks bottomed, their premium climbed to 7 points above Treasurys by March 2009, ushering in a new bull market. Now, some measures peg U.S. equities as the most expensive in the world, with the S&P 500 trading at a multiple of around 29—more expensive than it’s been 90% of the time since 1881. But high valuations don’t necessarily stem stock prices from going up, and the market is more resilient to rising interest rates now than in the past, the article contends. And looking only at the thin equity risk premium doesn’t account for the whole picture, says DeSpirito of BlackRock; in the wake of the 2008 financial crisis, the Fed’s intervention created an odd risk-reward profile. He advises that investors should avoid companies that are overvalued and look for stocks with buoyant margins and solid earnings growth instead. Meanwhile, value investors are pointing to value’s trouncing of growth last year. Though growth is ahead again, value could well be the long-term winner, as they have outperformed growth by 6 to 8 points a year during times when inflation is between 4% to 8% a year. Says founder of Research Affiliates and well-known value guru Rob Arnott, “inflation is wonderful for value.”