For years, Harry’s been parking $3 million of his $7 million portfolio in two-year Treasuries. And until recently, that allocation’s been a lousy investment. In all of 2020 and 2021, the bonds paid 0.2% a year on average, giving Harry a piddling $6,000 annually. Over those 24 months, Harry missed a 40% run-up in the S&P 500 by choosing T-notes over equities. “I must admit, that’s a heck of a price to pay for safety,” Harry admitted to me. But in 2022 as inflation surged and the Fed rapidly hiked rates to fight the onslaught, the yield on two-year Treasuries exploded, rising five-fold from under 1% at the year’s start to 4.4% on the final day of trading. In 2023, Harry’s $3 million in T-notes paid him $140,000 at an average rate of 4.6%, twenty-three times the number from 2020 to 2022. That’s also three-fold the 1.5% yield Harry was receiving in the five years before the rate fell to near zero at the start of the pandemic.

Why stocks look so risky right now compared to risk-free Treasuries

Harry keeps his portfolio’s $4 million balance in stocks. It’s hardly surprising that his taste in equities is also highly conservative. His holdings comprise only reliable dividend payers that aren’t terribly expensive based on their PE multiples; among his top choices are Procter & Gamble, Johnson & Johnson, and Coca-Cola. “But my stocks are only paying 3% in dividends on average,” he says. “That’s less than the almost 5% I’m now getting on my t-notes.” Harry’s planning to lighten up on equities, and increase the portion of his overall portfolio devoted to Treasuries.

Harry’s reasoning? He thinks stocks are no longer paying a big enough margin over Treasuries to be a good buy overall. Forget about the glamor tech contingent. For Harry, AI’s got loads of potential, but he’s clueless if the revolution will generate the expected earnings boom already built into the valuations of such high-flyers as Nvidia and its confreres in the Magnificent Seven. He wouldn’t dream of betting on Tesla, reckoning he’ll be long gone before Elon’s robotaxis hit the road.

In general, Harry’s worried that stock prices keep rising while earnings go flat. “Stocks are looking really expensive to me, which means that except temporarily, prices can’t just keep going up from here, so the returns going forward will be low,” he told me. “There’s also a big risk the S&P will fall, just ’cause big caps stocks overall are so pricey. So getting 5% with no risk looks at least as good as my 3% dividend yield or better, because even my stalwarts like Coke and P&G are expensive versus history. Not to mention the S&P 500 is paying a dividend of just over 1%, and you’re facing loads of risk the index will fall a lot.”

The stock market’s got a major math problem

Harry’s point about “not getting paid enough for risk” jibes with the market math—and the market has a big math problem. My friend’s investment approach follows the common-sense school. He’s by no means a finance wonk. But Harry hit on precisely the reason why the equity markets are so fragile right now: Run the numbers, and you’ll find that stocks are offering a super-slender premium over what super-safe Treasuries are paying. That cushion may not be wide enough given the manifold threats menacing the U.S. economy (elevated commodity prices, sticky inflation, the unbridled rise of federal debt, boiling tensions in the Middle East and Asia, to name a few).

So just how much are equity investors reaping over Treasuries while confronting a future fraught with danger? As of May 4, the S&P 500’s PE stood at 27.1, based on trailing, 12 month GAAP earnings of $191 per share. If the multiple remains at the formidable level of 27, the investors would be “earning” a 3.7% “real” or inflation adjusted return from dividends and capital gains. (That’s the profits of $3.70 for each $100 you’re paying.)

How does that likely gain stack up against the returns on the safest competing fixed income choice, 10 year Treasuries? They’re paying 4.5%, which is 2.21% higher than the expected annual inflation rate of 2.29% over the next decade. Hence, after accounting for predicted increases in the CPI, stocks are “yielding” only 1.49% more than bonds. (The 3.7% “real” yield on stocks minus the 2.21% real yield on the 10-year.)

How does that extra return compare with past periods? From mid-2021 to mid-2023, the “real yield” on the 10-year averaged 0%. The S&P’s PE hovered around 25, putting the expected return on the big cap index, the inverse of the multiple, at roughly 4%. So the “equity risk premium” investors garnered from owning stocks instead of bonds was also 4%, more than twice today’s number. Over the past several decades, the ERP has averaged in the 3.5% range.

Put simply, stocks are now offering a 1.49% edge that’s less than half the historic average and one-third the premium that reigned two years ago. That’s all the juice you get for shouldering the vagaries of this volatile market whipsawed by far more than the usual uncertainties. Harry recognizes that a great shift has suddenly made bonds a far better deal compared with stocks, and he expects to profit from the reversal—and a big wave of investors may soon reach the same conclusion.

Harry stands out as a numbers man only when tracking his golf handicap. At an 18, he’s a veteran duffer who, upon missing the fairway, never shoots for the greens and always lays up. But on the basis of market math, Harry just shot an eagle.