The outlook for U.S. corporate earnings has weakened as bond yields have shot higher. Many investors are now wondering if the case for owning bonds is stronger than it is for stocks in the coming months, or maybe even years.
I illustrate this question below with two charts. The first is a look at the evolution of S&P 500 earnings-per-share estimates for 2023, and the second is a look at the 10-year and 30-year U.S. Treasury bond yields since 2020. Readers can see how the allure for stocks appears to be falling while bonds are paying significantly higher risk-free rates.1
Zacks Investment Research2
Source: Federal Reserve Bank of St. Louis3
In the investment world, comparing the earnings yield on stocks with the yield on U.S. Treasuries is how you measure the equity risk premium. This metric tells investors the excess return over the risk-free rate they can expect from investing in the stock market. The theory goes that the higher the equity risk premium, the stronger the case for stocks versus bonds.
As a quick refresher for readers who may not be familiar, a stock’s earnings yield is the inverse of its P/E ratio, meaning that it’s the ratio of last year’s profits to the current stock price (E/P). In my view, comparing the E/P to long-duration Treasury bond yields is somewhat of a flawed comparison from the get-go, since the earnings yield considers past profits, not future ones. I’m a firm believer that a stock’s future returns hinge on expected and realized profits in the next year or beyond, not what the company delivered last year.
Comparing the current E/P of the S&P 500 (~4.5%) to the current yield on the 10-year U.S. Treasury bond (~3.4%)4, reveals a relatively small equity risk premium – the lowest it’s been since October 2007 when stocks were trading at high valuations (a high ‘P’ value in the E/P ratio) and 10-year Treasury bond yields were around 4.5%. Comparing the current forward earnings yield on the S&P 500 (~5.5%) to the 10-year widens the gap to about 2%, which is still well below the average equity risk premium of 3.5% since 2008.
Stock investors may see this and wonder: shouldn’t a below-average equity risk premium warrant some caution and/or rebalancing? The financial media often frames it that way, but in reality, the average equity risk premium over the last 65 years is 1.62% – pretty much right in line with where the market is today. I’d also point out that our outlook throughout 2023 and into 2024 is for corporate earnings to recover (first chart below), while interest rates likely level off or even come down slightly (second chart, which shows median expectations for fed funds in the next three years). By our estimates, the equity risk premium has a better chance of rising over the course of the year than shrinking.
Zacks Investment Research5
Source: Federal Reserve Bank of St. Louis6
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 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 recover, and the Fed to pause interest rate increases – all of which bolster the case for equities even as Treasuries now offer a more attractive risk-free rate.
1 Wall Street Journal. April. 6, 2023. https://www.wsj.com/articles/stocks-havent-looked-this-unattractive-since-2007-78fc374c?mod=hp_lead_pos3
2 Zacks.com. April 5, 2023. https://www.zacks.com/commentary/2075142/bank-earnings-looming-what-can-investors-expect
3 Fred Economic Data. April 10, 2023. https://fred.stlouisfed.org/series/DGS10#
4 U.S. Department of the Treasury. 2023. https://home.treasury.gov/resource-center/data-chart-center/interest-rates/TextView?type=daily_treasury_yield_curve&field_tdr_date_value_month=202304
5 Zacks.com. April 5, 2023. https://www.zacks.com/commentary/2075142/bank-earnings-looming-what-can-investors-expect
6 Fred Economic Data. April 10, 2023. https://fred.stlouisfed.org/series/DGS10
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