After being written off as irrelevant for much of the past decade, the equity risk premium, a gauge of the potential reward investors might reap from buying stocks, has fallen to its lowest level since 2007.
To some, this means U.S. stocks are no longer worth the risk now that investors can reap returns of 5% or more by buying short-dated Treasurys and other high-grade bonds.
In the years that followed the financial crisis, many investors disregarded the ERP as U.S. stocks moved reliably higher, their valuations bolstered by rock-bottom interest rates imposed by the Federal Reserve.
Some investors had a name for this phenomenon: TINA, which stands for “There Is No Alternative” — meaning that, with bond yields so low, investors were highly motivated to put their money to work in the stock market.
Now the situation has reversed. As inflation and expectations of a more difficult economic environment weigh on expectations for corporate profits, the nearly guaranteed returns offered by Treasurys has soared. This means the equity risk premium is once again finding use as a gauge of relative value for stocks, since it can offer helpful insights about what investors stand to gain over the short term by taking the additional risk that comes with buying stocks, or investing in stock funds.
Methods for calculating the ERP vary. Some economists like to include measures of inflation in their calculation to produce what’s known as the “real” equity risk premium (“real” in this case means the figure is adjusted for inflation, which is subtracted from the bond yields used in the equation).
How to calculate the equity risk premium
Others simply use analysts’ forecasts for how much profit S&P 500 companies are expected to earn over the coming 12 months.
As of Friday’s close, the equity risk premium stood at 1.7%, according to FactSet data.
Investors can arrive at this figure by taking Wall Street’s projected earnings per share over the next year for the S&P 500 — in this case $221.68, according to FactSet data — and divide it by the level of the S&P 500, which stood at around 3,970 as of Friday’s close. The result is multiplied by 100, to arrive at roughly 5.6%. Investors then subtract the current risk-free rate — in this case, the 10-year Treasury yield, which stands at 3.920% — to reach the final figure.
“That’s not that much,” said Liz Young, head of investment strategy at SoFi, who spoke with MarketWatch after sharing a chart of the ERP on Twitter.
“Basically, what it’s telling you is you have to pay a lot for this level of risk,” Young said, referring to U.S. stocks. “It’s not a great entry point for a lot of different reasons.”
What does this mean for the market?
While a low ERP might be good news for bonds, it could also mean that investors willing to wait out the tumult might walk away with a good deal. That’s because historically, a low ERP is correlated with recessions and bear markets, according to former New York Fed economist Fernando Duarte, who wrote about the ERP in a 2015 paper and in a New York Fed blog post from December 2020.
Although the U.S. economy isn’t in a recession as U.S. GDP growth remains robust, the S&P 500 did enter bear-market territory last year. The large-cap index is still down roughly 17% from 4,796.56, its record high, reached Jan. 3, 2022, according to FactSet.
Meanwhile, investors looking to outperform the broader market will need to be more discerning when deciding which stocks to buy. Young and others expect firms with resilient business models, low debt and the ability to continue generating cash even when the economy shudders to prevail.
“Knowing how certain companies make their profits, and how resilient those profits or cash flows are, will be key,” said Callie Cox,U.S. investment analyst at eToro, during a phone interview with MarketWatch.
Steve Eisman, the former hedge fund portfolio manager who shot to fame thanks to “The Big Short,” said Monday that he’s buying bonds “for the first time in a long time.” Even as tech stocks have led a market rebound since the start of the year, Eisman believes the days of banking market-beating returns by investing in tech stocks are over.
U.S. stocks bounced after suffering their biggest weekly drop of the year on Friday. The S&P 500 SPX, +1.30% closed 0.3% higher on Monday after finishing the week down 2.7% on Friday, according to FactSet data. The Dow Jones Industrial Average DJIA, +0.98% gained 72.17 points, or 0.2%.
Treasury yields, meanwhile, pulled back slightly, but the 10-year yield TMUBMUSD10Y, 3.595% is still on the cusp of crossing above 4% for the fist time since last fall. It pulled back to 3.921% Monday, down 2.7 basis points on the day.
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