The U.S. stock market has just entered unfamiliar territory. The equity risk premium (ERP) for the S&P 500 — essentially the extra return investors expect for taking on stock market risk over safer assets like Treasury bonds — has evaporated, hitting zero for the first time in more than 22 years.
This signals that, right now, investors aren't getting any additional reward for choosing risky assets like stocks over risk-free assets like bonds.
The ERP is calculated by subtracting the 10-year Treasury yield from the S&P 500's earnings yield.
Veteran economist David Rosenberg commented on the trend via social media.
"With this move in bond yields, we are now just 10 basis points away from the Equity Risk Premium shifting negative. Ergo, investors are willing to pay to take on equity risk instead of getting paid to,” he said.
Why Does The Equity Risk Premium Matter?
The equity risk premium is a critical barometer for investors, helping to gauge whether the potential return from equities justifies their higher risk compared to bonds.
A high ERP suggests investors are being well-compensated for stock market risk, while a low ERP indicates a slimmer reward.
In simpler terms, a low ERP means that stocks are becoming less attractive relative to bonds, as bonds now offer a similar return with far less risk.
A negative ERP has been a precursor to market instability or even bubbles, as it happened prior to the dot-com bubble. However, it's not a crystal ball — markets are unpredictable, and many factors can drive stock performance beyond just the ERP.
Should Investors Be Worried?
It's easy to assume that a zero ERP spells trouble for the stock market, but history provides a more nuanced view.
According to Alliance Bernstein, a prominent asset management firm, low ERPs aren't always the doomsday signal they appear to be. For example, between 1983 and 2008, the ERP was often around 1%, yet the S&P 500 delivered a 10.2% annualized return during that period.
"Future conditions may well be different than in the past, and the lower ERP does set the bar higher for equities," Alliance Bernstein wrote in a December 2023 report. "Still, history suggests that stocks can still deliver solid returns in higher-bond-yield environments."
While the sharp rise in bond yields has given investors a tempting, low-risk alternative to stocks, Alliance Bernstein highlighted that the stock market can still serve as a strong hedge against inflation.
During periods of moderate inflation (2-4%), the S&P 500 — as tracked by the SPDR S&P 500 ETF Trust SPY — has historically returned 2.5% per quarter, preserving purchasing power for investors. This inflation-protective quality can make stocks a valuable component, even when bonds yields look attractive.
In 2023, even with an extremely low ERP, the U.S. stock market continued its upward march, disproving the predictive power of the metric.
Don't Rely On ERP Alone For Market Timing
Famed valuation expert and finance professor Aswath Damodaran cautioned investors against using the equity risk premium or earnings yields as market-timing tools.
"If you are using equity risk premiums or even earnings yield for market timing, recognize that having a high R-squared or correlation in past returns will not easily translate into market-timing profits," Damodaran said.
"Even if the correlations and regressions hold, you may still find it hard to profit from them, since you (and your clients, if you are a portfolio manager) may be bankrupt before your predictions play out," Damodaran added.
Bottom Line: A New Landscape, But Not Necessarily A Crisis
With the equity risk premium at zero, stock investors face a challenging environment where the reward for taking on equity risk has practically vanished.
While this may push some to reconsider their allocations, it doesn't mean stocks are doomed.
History shows that low ERPs don't always precede a downturn, and stocks can still deliver solid returns in a high-yield world.
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© 2024 Benzinga.com. Benzinga does not provide investment advice. All rights reserved.
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