Author: Jamie McGeever
ORLANDO, Fla. (Reuters) – The theory suggests that the value differentials between U.S. stocks and bonds will eventually become so extreme that investors will have to reduce their exposure to ultra-expensive stocks and start loading up on depleted government bonds. If America’s so-called ‘equity risk premium’ (ERP) is anything to go by, that point may soon be upon us.
ERP can be measured in different ways, but it is essentially the difference between the earnings yield on and . In ‘normal’ times, ERP should be positive, offering investors a reasonable premium for holding equities over ‘risk-free’ government debt.
These are not normal times after all. Longer-term bond yields are rising even as the Federal Reserve has begun to cut interest rates, while sticky inflation and a worrying trajectory of Washington’s debt and spending worries investors.
Meanwhile, the AI craze and the narrative of ‘American exceptionalism’ led by a handful of Mega Cap tech stocks fueled a boom on Wall Street that lifted totals to their highest levels in years – or even decades by some measures.
As a result, the ERP collapses. According to some indicators, it is the lowest in almost a quarter of a century, it even slipped into the red. If the 10-year bond yield continues to rise, the ERP is likely to decline further.
So stocks look expensive, nominally and relative to bonds, but does that mean it’s time to sell?
AMBER TO GREEN
This situation is ringing alarm bells for many equity strategists. A team at Societe Generale ( OTC: ) calculated that a rise in the 10-year yield to 5.00% would push ERP into “unhealthy territory” although it would likely not cause much damage to the S&P 500. They argue that the “buy” signal for bonds will flash stronger when the treasury yield approaches the growth of the nominal trend, currently around 5.2%.
“We believe this should be the anchor point for bond fears on the growth outlook and the point at which US bonds become fundamentally attractive,” they wrote this week.
The 10-year yield hit 4.79% on Friday, the highest since November 2023, and more than 100 basis points higher than when the Fed began cutting its benchmark rate in September.
Of course, there is no single trigger for buying stocks or bonds, much less a specific number or metric of individual relative value. Adjusting a portfolio is a complex and often time-consuming consideration, and investors currently have to navigate a host of unknown variables such as the new Trump administration’s trade policies and the Fed’s next steps.
Moreover, ERP can send different signals depending on what drives it and the broader macroeconomic context.
UNSUSTAINABLE
In March 2009, the ERP jumped to an all-time high of 7% as bond yields fell to near zero following the collapse of Lehman Brothers six months earlier. March 2009 turned out to be a low for the stock market, with the S&P 500 falling to a chilling 666 points.
Similarly, ERP’s jump towards 6% in April 2020 at the start of the COVID-19 pandemic was driven by falling Treasury yields and also signaled a decline in the stock market.
Today’s view is that the recent decline in ERP is primarily driven by a sharp rise in yields, suggesting that bonds are becoming attractive on a relative value basis.
Investors tend to like nice round numbers, so the 10-year bond yield of 5.00% would likely attract some buyers, but portfolio managers may be hesitant to invest all in, given the current uncertainty surrounding US fiscal and monetary policy.
As Unlimited’s Bob Elliott notes, it’s an unsustainable divergence — either yields have to fall enough to justify current stock prices, or stocks have to fall to reflect higher rates.
The “buy bonds” and “sell stocks” signals may flash yellow, but determining when they turn green remains a challenge.
(The opinions expressed here are those of the author, a Reuters columnist.)
(Author: Jamie McGeever; Editing: Andrea Ricci)
