A Gap That Isn’t Worth Minding Much

Are stocks still worth the added risk? A prominent piece in Monday’s Wall Street Journal explored the “no” argument, citing the dwindling gap between the S&P 500’s earnings yield and 10-year government bond yields.^[i] This gap, known as the equity-risk premium, theoretically represents how much stocks compensate investors for taking extra risk versus staid Treasurys. It also happens to be at its lowest in over 20 years, leading some to question the young bull market’s staying power—and others to argue the signal is mostly noise. We are inclined to agree with the latter viewpoint. Here are four charts and some words to show you why.

The equity-risk premium is straight out of finance textbooks, but we don’t hold that against it—it can actually show some useful things about sentiment. Stocks’ earnings yield—the inverse of the price-to-earnings (P/E) ratio—is a nifty, theoretical, back-of-the-envelope estimate of the long-term return you would get, excluding dividends, if earnings stayed constant. Obviously, it is not a real-world return, because stocks do pay dividends, earnings fluctuate every quarter—and usually grow over time. It also doesn’t predict stock returns because, like the P/E ratio, it is a widely known derivative of past performance—priced in, already happened. However, like P/Es, it can hint at sentiment. And when compared to bond yields, it can show how sentiment toward stocks compares to bonds.

Where things run aground is when people start looking at earnings yields and the equity-risk premium compared to the long-term average and start making mean-reversion arguments. As in, the gap is so wide stocks have to rise or fall a certain amount to get to parity or the long-term average. Or, the gap is so narrow stocks must be running out of gas—as some argue today. Tied to that is the simple hypothesis that with earnings yields quite low right now, stocks don’t have much to offer.

Whenever we see blanket statements like this, we like testing them. So let us test! Exhibit 1 shows the difference between the S&P 500’s 12-month forward earnings yield and 10-year US Treasury yields since the end of 1995. You will see bull markets with low and negative spreads, bull markets with middling spreads and bull markets with high spreads. You will also see bear markets with low or negative spreads, rising spreads and falling spreads. To us, all this proves is that the equity-risk premium isn’t predictive. Stocks and bonds have different drivers. Interest rates just aren’t everything for markets. It is that simple.

Exhibit 1: A Long Look at the Equity-Risk Premium

Source: FactSet, as of 7/31/2023. S&P 500 12-month forward earnings yield and 10-year US Treasury yield (constant maturity), 12/31/1995 – 7/28/2023.

Exhibit 2 provides another way to see this by adding the S&P 500’s 12-month forward returns to the mix. As you will see, the low and negative spreads in the late 1990s preceded good returns as well as the 2000 – 2002 bear market. In the 2010s, there were multiple points at which a healthy equity-risk premium preceded negative stock returns. Here, too, there isn’t much evidence of predictive power.

Exhibit 2: A Long Look at the Equity-risk Premium and Forward Stock Returns

Source: FactSet, as of 7/31/2023. S&P 500 12-month forward earnings yield, 10-year US Treasury yield (constant maturity) and S&P 500 total return index, 12/31/1995 – 7/28/2023.

Then again, the equity-risk premium claims to say something about stock returns relative to bonds, so let us see if relative returns are more telling. Exhibit 3 replaces forward stock returns with the difference between the S&P 500’s 12-month forward return and the ICE BofA US 7 – 10-year Treasury Index’s 12-month forward return. That is, the margin by which stocks out- or underperformed bonds on a total return basis over the next year. It probably doesn’t surprise you to see stocks trailed bonds more often than not during bear markets. But you might be surprised to see several points in the 2010s where stocks lagged bonds even though the equity-risk premium said they should be leading. Similarly, the late 1990s’ collapsed spreads preceded plenty of stock outperformance.

Exhibit 3: A Long Look at the Equity-risk Premium and Forward Relative Returns

Source: FactSet, as of 7/31/2023. S&P 500 12-month forward earnings yield, 10-year US Treasury yield (constant maturity), S&P 500 total return index and ICE BofA US 7 – 10-year Treasury total return index, 12/31/1995 – 7/28/2023.

For grins, we also ran a version of this analysis with 24-month forward returns to see if that smoothed out some of the noise. It did, to an extent, but the counterpoints to the conventional wisdom remained.

Exhibit 4: A Long Look at the Equity-risk Premium and Slightly Longer Forward Relative Returns

Source: FactSet, as of 7/31/2023. S&P 500 12-month forward earnings yield, 10-year US Treasury yield (constant maturity), S&P 500 total return index and ICE BofA US 7 – 10-year Treasury total return index, 12/31/1995 – 7/28/2023.

Therefore, we think it is an error to draw sweeping conclusions from today’s narrow spread—especially when you consider why it has collapsed. On the bond side, yields are still up tied to Fed hikes and inflation sentiment. On the stock side, we are nine and a half months into a young bull market, which is unfolding like bull markets usually do, with stocks rising before earnings recover. This is just stocks’ normal pre-pricing and pre-telling behavior. Last year, they pre-priced the forthcoming earnings decline, then they got it out of their system and started pre-telling the eventual recovery. But parallel to that, the actual earnings decline has unfolded. Therefore, the P in the P/E ratio is up while the E is down. A higher P/E means a lower earnings yield, just from new bull market skew. As earnings eventually recover, it should lower the P/E and raise the earnings yield even if stock prices keep rising, as has happened in the past. Presuming 10-year yields don’t spike again (and with inflation slowing, we don’t see much likelihood they will), that points to a widening equity-risk premium amid a broader bull market.

Not that this would be predictive! It might point to and influence improving sentiment, but that is about it. But it would also debunk today’s claim that stocks must sink for the spread to widen again.