The rewards of owning stocks instead of bonds were not so small before the 2008 financial crisis.
The equity risk premium — the spread between the S&P 500’s earnings yield and the 10-year Treasury note — is about 1.59 percentage points, the lowest since October 2007.
That’s well below the average spread since 2008 of about 3.5 basis points. This decline spells trouble for stocks going forward. Stocks should promise higher returns than bonds over the long term. Otherwise, the safety of Treasuries outweighs the risk of stocks losing some, if not all, of investors’ money.
As bond yields have risen recently and the corporate earnings picture continues to darken, the appeal of stocks has waned. The Federal Reserve now faces the dual challenge of raising interest rates to calm inflation while using its toolbox to prevent the onset of a full-scale banking crisis that could cloud the outlook for stocks. .
The S&P 500 recovered some of last year’s 19% decline, rising 6.9% in 2023. The Bloomberg U.S. Composite Bond Index rose 4.2%, boosted by a recovery earlier in the year and higher yields.
The S&P 500 rose 0.4% on Thursday after jobs data showed the Fed was winning its fight against a record labor market. Bond yields rose slightly.
BlackRock Inc. Bonds offer a “once-in-a-generation opportunity,” but not a once-in-a-lifetime opportunity, said Tony DeSpirito, chief investment officer for U.S. fundamental equities.
The current equity risk premium is close to the long-term norm: The average premium since 1957 is about 1.62 basis points, according to BlackRock research. That means stocks should outperform bonds given their past performance, DeSpirito added.
The equity risk premium falls when bond yields rise or when the price-earnings ratio of stocks falls, or when stock prices rise. Earnings yield, on the other hand, is the ratio of the previous year’s earnings to the current stock price.
October 2007 was a volatile period in the markets. Stocks recently hit record highs, and the yield on stocks is close to its current level of about 4.8%.
Next year, the S&P 500 will continue to decline by about 45% and the Fed will cut rates to zero. Restoring the increased price of shares; bond yields fell sharply. When the stock market bottomed in March 2009, the premium on Treasuries exceeded 7 points and a new bull market was born.
Stocks look expensive again today and markets face new challenges. By at least one valuation measure, U.S. stocks are currently more expensive than stocks in any other country or region, according to Research Affiliates. This is based on the S&P 500’s price-to-inflation-adjusted corporate earnings, or CAPE, ratio over the last 10 years. While far from past highs between the late 1990s and 2021, the benchmark U.S. equity index is trading at a multiple of about 29, more than 90% since 1881.
Prices have historically fallen during economic downturns, although some analysts say higher prices don’t stop stock prices from rising.
“We’ve seen a peak in stock valuations, but that doesn’t mean we’ve seen the highest valuations in this cycle,” said Javad Mian, founder of macro advisory firm Stray Reflections.
The economy is much more resilient to higher interest rates than it used to be, Mian said. Higher nominal growth, boosted by inflation, will continue to support earnings more than the Wall Street consensus suggests, preventing a significant drop in share prices, he said.
According to FactSet, analysts expect earnings for S&P 500 companies to grow about 1.6% in 2023. At the end of last year, they asked for a 5% increase.
Since 1957, stocks have outperformed fixed income more than two-thirds of the time they’ve been held for at least a year, according to BlackRock research. As the holding period increases, the benefits to the stock improve.
Focusing on stocks’ thin risk premium misses part of the picture, said BlackRock’s DeSpirito. The Fed’s intervention — by cutting short-term rates and buying long-dated bonds — created an unusual risk-reward profile for stocks after the 2008 financial crisis. This encourages investors to avoid overvalued companies and look for stocks with stable margins and strong earnings growth.
Some investors say that bubble valuations mean value stocks — trading below their book value or net worth — are worth considering.
According to Rob Arnott, founder and president of Research Partners, value stocks are “extremely cheap” relative to growth, cheaper than four-fifths of the time in US stock market history.
While value funds outperformed their growth peers last year, growth funds again took the lead. The Russell 3000 Growth Index is up 13% in 2023, while the Russell 3000 Value Index is up 0.1%.
When inflation fluctuated between 4% and 8% a year, value stocks outperformed growth by 6 to 8 percentage points a year, Arnott said. Consumer prices rose 6% in February from a year earlier, the smallest increase since September 2021.
“Inflation is great for value,” he added.
Write to Eric Wallerstein at eric.wallerstein@wsj.com
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