The stock market has been on a roll this year, with the S&P 500 gaining a remarkable 17%. However, despite a solid earnings season, most of these gains can be attributed to the expansion of the index’s price/earnings ratio. On December 30, the ratio stood at 16.8 times, but by August 7, it had increased to 19.2 times. This is also above the index’s 10-year average of 17.67, making stocks appear expensive.
But let’s not forget that stocks are just one investment option among many. For investors, it’s crucial to consider the “equity risk premium,” which refers to the extra yield investors can expect from buying stocks rather than bonds. To determine the earnings yield on stocks, we can use the E/P ratio instead of the traditional P/E ratio. By comparing this number to the 10-year bond yield, we can get a better sense of the value proposition.
Currently, with an earnings yield of 5.208%, the S&P 500 seems to be underperforming its 10-year average of 5.76%. This alone would be cause for concern. However, when we look at the 10-year Treasury yield, which has risen to 4.089% from its 10-year average of 2.24%, things become even more worrying. As a result, investors are only receiving an additional 1.119 percentage points of yield for investing in stocks, compared to the 10-year average of 3.52 percentage points.
In summary, the rising bond yields have made an already expensive stock market look even more costly. Investors need to carefully assess their options and consider that stocks may not provide as much extra yield compared to bonds as they have in the past.
The Impact of Rising Treasury Yields on the Stock Market
Treasury yields are on the rise, and while the reasons behind this increase may vary, it is not the main concern for investors. It could be due to improved long-term growth prospects or the Treasury Department issuing more bonds, which puts pressure on bond prices and subsequently increases their yields. However, what truly matters is the impact this has on the equity risk premium and its effect on the S&P 500.
At present, the equity risk premium is extremely low, leading to a notable underperformance of the S&P 500. RBC strategists have calculated a slightly different earnings number that places the current risk premium just below 1%. Although there are instances where a low risk premium has not hindered stock market gains, historically, it has often preceded significant market selloffs. This was observed in the early 2000s when the equity risk premium was at similar levels before the dot-com bubble burst, causing a 20% decline in the S&P 500 over the following year.
While it may seem tempting to invest in stocks at this juncture, there are considerable risks involved. Although earnings are projected to grow in the coming years, there is also a possibility of yields decreasing. Prudent investors should be patient and wait for better opportunities to arise.
