As Treasury yields continue to march higher, the expected benefits of owning U.S. stocks over bonds is looking increasingly unattractive.
The so-called equity risk premium, which gauges the excess return investors should expect from owning stocks over bonds, has as of Tuesday’s close shrunk to its lowest level since June 18, 2002 at 0.642, according to Dow Jones Market Data.
It’s just the latest milestone for the ERP, which has been shrinking all year, drawing the attention of equity analysts after more than a decade of near-irrelevance.
Some have speculated that the ERP could soon break below zero for the first time since the first half of 2002. According to Dow Jones data, which uses the nominal 10-year Treasury yield as an input in its ERP model, the last time this occurred was on May 23, 2002, when the premium shrank to minus 0.055 percentage points.
As MarketWatch explained earlier this year, one popular method for calculating the ERP involves taking Wall Street’s projected earnings per share over the next year for the S&P 500 index companies and dividing it by the level of the index, then multiplying the quotient by 100.
Afterwards, you subtract the risk free interest rate, in this case the yield on the 10-year Treasury note, from the result to arrive at the final number, which is expressed in percentage points.
Stocks are seen as inherently more risky than bonds because they offer investors nothing should a company fail. Bondholders, like other lenders, can typically at least recover some of the principal during the bankruptcy process. Bond investors also earn steady cash flows in the form of coupon payments, while not all stocks pay dividends to shareholders. Therefore, stock investors should, at least in theory, demand compensation to offset this additional risk. The ERP attempts to measure exactly what this compensation is.
U.S. stocks have fallen since the beginning of August as Treasury yields, particularly yields on long-dated Treasurys, have climbed to their highest levels since 16 years. Yields on the 10-year
BX:TMUBMUSD10Y
and 30-year Treasurys
BX:TMUBMUSD30Y
hit fresh highs on Wednesday, which helped spur a selloff in stocks. The S&P 500
SPX,
which has fallen 4.5% since Aug. 1, was on track to finish 1.5% lower at 4,307 in recent trade, according to FactSet data.
This post was originally published on Market Watch
