What does a lower equity risk premium mean for investors?

Higher Treasury yields and weakening corporate earnings have strengthened the case for bonds over stocks—but it's important to consider what's ahead for both. [Mitch on the Markets] The Equity Risk Premium is Shrinking: What That Means for Investors The outlook for U.S. corporate earnings has weakened as bond yields have shot higher. Many investors are now wondering if the case for owning bonds is stronger than it is for stocks in the coming months, or maybe even years. I illustrate this question below with two charts. The first is a look at the evolution of S&P 500 earnings-per-share estimates for 2023, and the second is a look at the 10-year and 30-year U.S. Treasury bond yields since 2020. Readers can see how the allure for stocks appears to be falling while bonds are paying significantly higher risk-free rates.1 --------------------------------------------------------------- [How Should You Allocate Your Investments This Year?]( What does the current market mean for your investments? Our just-released April Stock Market Outlook Report will give you an in-depth look into the current state of treasuries and stocks and the best place to invest. You will also get insight on: - Zacks forecasts for the months ahead - Current asset allocation guidelines - Zacks Rank industry tables - Our latest commentary and outlook on equity markets - And more… If you have $500,000 or more to invest and want to learn more about these forecasts, click on the link below to get your free report today! [Download Our Just-Released April 2023 Stock Market Outlook Report 2]( --------------------------------------------------------------- [Evolution of S&P 500] Source: Zacks Investment Research 3[Market Yield on U.S. Treasury Securities] Source: Federal Reserve Bank of St. Louis 4 In the investment world, comparing the earnings yield on stocks with the yield on U.S. Treasuries is how you measure the equity risk premium. This metric tells investors the excess return over the risk-free rate they can expect from investing in the stock market. The theory goes that the higher the equity risk premium, the stronger the case for stocks versus bonds. As a quick refresher for readers who may not be familiar, a stock’s earnings yield is the inverse of its P/E ratio, meaning that it’s the ratio of last year’s profits to the current stock price (E/P). In my view, comparing the E/P to long-duration Treasury bond yields is somewhat of a flawed comparison from the get-go, since the earnings yield considers past profits, not future ones. I’m a firm believer that a stock’s future returns hinge on expected and realized profits in the next year or beyond, not what the company delivered last year. Comparing the current E/P of the S&P 500 (~4.5%) to the current yield on the 10-year U.S. Treasury bond (~3.4%)5, reveals a relatively small equity risk premium – the lowest it’s been since October 2007 when stocks were trading at high valuations (a high ‘P’ value in the E/P ratio) and 10-year Treasury bond yields were around 4.5%. Comparing the current forward earnings yield on the S&P 500 (~5.5%) to the 10-year widens the gap to about 2%, which is still well below the average equity risk premium of 3.5% since 2008. Stock investors may see this and wonder: shouldn’t a below-average equity risk premium warrant some caution and/or rebalancing? The financial media often frames it that way, but in reality, the average equity risk premium over the last 65 years is 1.62% – pretty much right in line with where the market is today. I’d also point out that our outlook throughout 2023 and into 2024 is for corporate earnings to recover (first chart below), while interest rates likely level off or even come down slightly (second chart, which shows median expectations for fed funds in the next three years). By our estimates, the equity risk premium has a better chance of rising over the course of the year than shrinking. [Quarterly Earnings and Revenue Growth Rate YoY] Source: Zacks Investment Research 6[FOMC Summary of Economic Projections for the Fed Funds Rate, Median] Source: Federal Reserve Bank of St. Louis 7 Bottom Line for Investors The equity risk premium is a useful metric that investors can use in evaluating the stock-bond decision, but it’s certainly not the only consideration, in my view. Investors should also think about where they expect interest rates and earnings to be a year from now, which is another way of assessing whether the equity risk premium is expected to rise or fall looking forward. From my vantage, I expect inflation to moderate, earnings to recover, and the Fed to pause interest rate increases – all of which bolster the case for equities even as Treasuries now offer a more attractive risk-free rate. In our [Just-Released April 2023 Stock Market Outlook Report]( you have access to our forecasts for the months ahead and where to invest. You will also get a deeper insight into the following: - Zacks forecasts for the months ahead - Current asset allocation guidelines - Zacks Rank industry tables - Our latest commentary and outlook on equity markets - And more… If you have $500,000 or more to invest and want to learn more about these forecasts, click on the link below to get your free report today! 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