Monday, July 31, 2023

Risk premium for stocks near all time low

WSJ reports:  
The gap between the earnings yield of the S&P 500 and the yield on the 10-year U.S. government bond dropped to around 1.1 percentage point last week, its narrowest since 2002.
And here is the reason:
Bond yields haven’t risen as much, but stocks have taken flight—lifted by investors’ growing optimism about the economy.

In other words, investors are investing as if stocks are only slightly more risky than bonds.  If they change their minds, and think that stocks are more risky than bonds, stock prices will fall which will raise the expected return of investing in stocks or bond prices will rise which will decrease the bond yield, and bring the equity risk premium back up, closer to its mean.

This isn't the first time that the equity risk premium has fallen, See earlier posts to see past instances of this, like in 2008, when Vandy Treasurer Bill Spitz's advised:

  • Avoid Riskier assets 
  • Stick with quality 
  • Be skeptical of the rush to alternatives 
  • Moderate return expectations 
  • Borrow now if you are a marginal credit
But unlike 2008, the Shiller CAPE (cyclically adjusted price to earnings ratio, a measure of value) is not as high, though twice its long run mean of 16.  
DISCLAIMER:  if I really knew what was going to happen, I wouldn't be teaching school.

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