Thursday, April 6, 2023

Why is the stock risk premium so low?


WSJ article:

The equity risk premium—the gap between the S&P 500’s earnings yield and that of 10-year Treasurys—sits around 1.59 percentage points, a low not seen since October 2007.

What does this mean?  Investors have a choice between investing in stocks or bonds.  Stocks are historically more volatile/risky than bonds, so risk-averse investors have to be compensated for investing in stocks, with a return that is about 3.5% higher.  As of the end of March, 2023, the risk premium had fallen to less than half of that.   

In 2006, Bill Spitz (former Vanderbilt Treasurer), saw something similar (my 2006 Blog Post).  He noticed that the risk premia between returns on stocks vs. bonds, low vs. high quality stocks (low debt, high and stable profit margins), and emerging market debt vs. US debt were at all time lows.  Either the world had gotten less risky, or investors were ignoring risk in the search for higher return.  Spitz thought it was the latter which motivated his investment advice at that time: 

  • Avoid Riskier assets 
  • Stick with quality 
  • Be skeptical of the rush to alternatives 
  • Moderate return expectations 
  • Borrow now if you are a marginal credit  
The implication was that when investors stopped ignoring risk, the prices of riskier assets would fall, which would increase the risk premia.

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