The Stock Market Isn't Rewarding You for Risk Taking. That Could Spell Trouble.

Bond yields have been rising—and that means an already expensive stock market is looking even more expensive.

The
S&P 500
has gained about 17% this year, and despite a solid earnings season, most of the gains have come via expansion of the index’s price/earnings ratio, from 16.8 times on Dec. 30 to 19.2 times on Aug. 7. That’s also above its 10-year average of 17.67 In a vacuum, it’s safe to say that stocks look expensive.

But stocks aren’t in a vacuum. They are one choice for investors out of many. It’s one reason many people look at the “equity risk premium,” or the amount of extra yield investors can expect to get for buying stocks instead of bonds. Finding the earnings yield on stocks is relatively simple—instead of using a P/E ratio, an E/P ratio is used. Then it’s easy to compare that number to the 10-year bond yield.

At 19.2 times earnings, the S&P 500 has an earnings yield of 5.208%, below its 10-year average of 5.76%, which would be bad enough on its own. But the 10-year Treasury now yields 4.089%, up from its 10-year average of 2.24%. As a result, investors are getting just an extra 1.119 percentage points of yield for investing in stocks, down from a 10-year average of 3.52 percentage points.

Why treasury yields are rising doesn’t matter all that much. It might be because investors are pricing in better long-term growth prospects or because the Treasury Department is issuing more bonds, pressuring bond prices and lifting their yields. What matters is that when the equity risk premium is as low as it is now, the S&P 500 tends to underperform—and badly.

Strategists at RBC use a slightly different, but similar, earnings number, one that puts the current equity risk premium a bit below 1%. While there are times when the risk premium is fairly low and the stock market still manages to gain because markets expect continued earnings growth, a low premium has preceded many historical selloff. For instance, the ERP was around current levels in the early 2000s, just before the dot-com bubble burst, sending the S&P 500 down about 20% over the following 12 months.

Maybe buying stocks today will pay off. Earnings should grow next year and even for a while after that, while yields may dip from here. But then again, aggressively buying the market here comes with great risk.

For a prudent investor, better opportunities should present themselves.

Write to Jacob Sonenshine at [email protected]

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