Stocks and Bonds Offer Similar Yields. Does That Make Stocks Too Risky?
As I write, the S&P 500 trades at roughly 22x projected 2025 earnings, and the 10-year U.S. Treasury bond yields roughly 4.5%. That makes the earnings yields on stocks and bonds basically the same.
For clarification, the earnings yield on stocks is derived by dividing the stock market’s expected earnings by its price, which currently equals about 4.5%. When you compare this earnings yield with current bond yields, that gives you the equity risk premium, which theoretically tells investors how much extra reward stocks should offer over bonds.1
As readers can see, that reward is essentially zero today—which also marks the first time we’ve seen the equity risk premium this low since the tech bubble burst.
It is logical to assume that the lower the equity risk premium, the weaker the case for owning stocks versus bonds. After all, according to this metric, investors are not being compensated at all for taking the additional risk of owning stocks over Treasurys. There’s also the case of the late 1990s, when the equity risk premium turned negative and a bear market followed.
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In my view, there’s a very reasonable risk argument to be made here about the stock-bond decision. But where the argument starts to fall apart, in my view, is in assuming that a low or even slightly negative equity risk premium tells us anything about future returns. When we look back on history at the relationship between the equity risk premium and forward 12- or even 24-month returns on the S&P 500, the case for correlation fizzles. And there’s essentially no argument for causation.
In 1996, the equity risk premium fell below zero and stayed negative basically until the bear market started in early 2000 (the equity risk premium turned positive for a short time in 1998 with the market correction). Investors could have used this metric to get out of stocks in 1996, but that would have been a mistake. There was still plenty of runway left in that bull.
On the flip side, the equity risk premium was nicely positive—roughly 3%—at the start of the 2008 Global Financial Crisis, and there were periods in the 2010s when bonds outperformed stocks even though the equity risk premium suggested stocks were the better buy. As mentioned, it’s difficult to find a convincing correlation between the equity risk premium and forward returns. There have been many instances where the signal seems to work and others where it doesn’t.
The key thing to remember, in my view, is that stocks’ earnings yield—again, theoretically—tells investors what return they should expect over the long run if earnings stayed constant and no dividends were paid. But as we all know, many stocks pay dividends, and earnings are rarely constant. As we begin to parse Q4 2024 earnings, the picture that emerges is one of improving outlook, with companies not only coming ahead of estimates but also providing reassuring guidance for coming quarters (see chart below).
There’s a scenario where earnings come in far better-than-expected in 2025, while long-duration Treasury bond yields remain range-bound. That would be a positive scenario for stocks, in my view, regardless of whether the equity risk premium turned positive or not.
Bottom Line for Investors
The equity risk premium is a useful metric that investors can use in evaluating the stock-bond decision, but it’s certainly not the only consideration, in my view. Investors should also think about where they expect interest rates, inflation, and earnings to be a year from now, which is another way of assessing whether the equity risk premium is expected to rise or fall looking forward. From my vantage, I expect inflation to moderate, earnings to accelerate, and growth to continue above trend—all of which bolster the case for equities, in my view, even as Treasuries now offer a more attractive risk-free rate.
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Disclosure
2 ZIM may amend or rescind the guide “How Solid Is Your Retirement Strategy?” for any reason and at ZIM’s discretion.
3 ZIM may amend or rescind the guide “How Solid Is Your Retirement Strategy?” for any reason and at ZIM’s discretion.
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