With earnings growth, employment and even Fed policy supportive of equities, we’ve seen new highs this week. The Dow Jones Industrial Average touched 40,000 on Thursday before receding slightly. So, can equities keep moving higher? To answer that question, we dug into the equity risk premium.
The equity risk premium is a historical gauge of excess returns that can vary over time and across markets. As an indicator, it is often used to forecast relative performance between stocks and bonds and we’re testing that theory in this week’s note.
Understanding the equity risk premium as a long-term indicator
The equity risk premium measures the difference between the expected return from equities (the earnings yield or inverse of the price-to-earnings ratio) and the risk-free return (typically the U.S. 10-year Treasury yield). A low or negative equity risk premium implies that equities are potentially overvalued relative to bonds, suggesting a lower likelihood of equities outperforming bonds. As you can see in the chart, the equity risk premium has been moving lower and just turned negative.
We tested how strong a predictor equity risk premium can be for real excess returns in the charts below. To do so, we compared the earnings yield of the cyclically adjusted (for inflation) price-to-earnings ratio (“CAPE”) with real performance of stocks over bonds. The first chart here shows the equity risk premium on the x-axis and the 1-year real performance of stocks over bonds on the y-axis. As shown below, there is virtually no relationship between the equity risk premium and one-year ahead returns suggesting equity risk premium is a weak predictor of year ahead returns.
However, over a 10-year horizon, the equity risk premium becomes a much better predictor of future returns. The chart below is the same as above except instead of one year ahead returns, it compares the equity risk premium with 10-year (annualized) real excess return of stocks over bonds. Here, there is a much stronger relationship. The chart also shows that the current (CAPE-derived) equity risk premium of around 1.48% points to an annualized 10-year real outperformance of stocks over bonds of roughly 1.5%. This says to us that there is more risk to buying equities at these levels and outperformance of stocks over bonds is challenging in this environment.
Here are the two charts side by side.
Portfolio strategy
As we mentioned, we believe that cyclical supports – strong earnings, stable employment, and a dovish Fed – mean equity valuations could move higher. But these factors are subject to change. When they weaken, the cycle is already over, and markets can turn on a dime.
Add that the equity risk premium is low, so we believe long-term investors and asset allocators should proceed with caution. Based on current market valuations and interest rate levels, expecting stocks to significantly outperform bonds over the next decade might be overly optimistic.
So, should investors consider buying more bonds? Yes. Is the aggregate bond index the best bet? Not necessarily, in our view. We’ve been reminding our readers of the upward pressures on the long end of the curve. Namely, inflation expectations have held steady, and the term premium represents potential risk, in our view. We think a credit barbell of short duration high yield bonds and higher quality long-duration bonds, especially municipal bonds, will potentially continue to outperform the aggregate bond index. In this structure, investors could see more exposure to the rates at the front end of the curve where yields are higher while long-duration bonds could see more gains in a lower growth or recession scenario.
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