One of the best signals for when stocks are a great or poor deal is a metric called the Equity Risk Premium. It measures the market’s estimate of the future returns you can expect over the next decade from the S&P 500 versus what you’d garner from shouldering a lot less risk (and sleep far better) by holding 10-year Treasury notes. Put simply, the ERP’s a good proxy for the “margin of safety” that Warren Buffett says shareholders should cherish. Kenneth French, the distinguished financial economist at Dartmouth’s Tuck School of Business, described the ERP to this writer as “the holy grail of stock market investing.”
The ERP is simple to calculate. Start with the S&P 500’s earnings yield: the profits, over the past 12 months under standard GAAP accounting, that each $100 invested in the index is earning. Then subtract the “real” or inflation-adjusted yield on 10-year Treasuries, as measured by Treasury Inflation Protected Securities (TIPS). In other words, it’s the market’s best take on the annual return on stocks versus the anticipated number for super-safe government bonds.
Here’s what that looks like today. For every $100 invested in the S&P 500 you’re getting about $3.80 in earnings. For every $100 in 10-year TIPS, you’re guaranteed about $2.86 a year above inflation. The difference, less than $1, is your reward for riding out the stock market’s swings. But historically, that reward has averaged roughly $3.50.
The sudden rise in “real” rates has hugely shrunk the ERP
At midday on September 26, the 10-year TIPS yield hit 2.86%. That’s a 110 basis point jump since early March, and marks the highest level since it generally hovered above 3.5% from 1999 to 2001, except for a couple of weeks during the GFC when it surged slightly above today’s number amid the widespread panic. (In part of this period, the ERP actually went negative.) How about the earnings yield? It’s the inverse of the S&P PE of 26.2, or 3.8%. Hence, the ERP now stands at just below 1% (3.8% earnings yield minus the 2.86% TIPS yield). You’re getting a super-slender premium of roughly 1 point for riding the S&P roller coaster versus clipping fat coupons (the nominal 10-year yield is now a juicy 5.2%).
By this writer’s calculations, the only times in the past two-plus decades when the ERP sank below this level were a few months each during both the GFC and the COVID outbreak, when earnings totally collapsed, distorting the numbers by sending PEs to immense highs. Most academic studies gauge the ERP, measured from 1871, when economist Robert Shiller’s data sets begin, at an average of roughly 3.5%, almost 4x today’s level. (Since TIPS only started trading in 1997, it’s difficult to assess the ERP for earlier periods.)
In recent decades, the yardstick got a boost via exceptionally low real rates. From August 2010 to December of 2022 (except for part of the COVID upheaval), the TIPS yield averaged just 0.6%. That’s a return barely above inflation. And though stocks were relatively pricey at a 20 PE, they still looked terrific vs. bonds. The S&P 500 was handing you a 5% earnings yield (inverse of the 20 multiple). That 5 points minus the 0.6 figure for the 10 year TIPS provided a sterling ERP of 4.4%. Big caps were offering one of the most sumptuous cushions over bonds ever seen.
Since then, the scenario has stunningly reversed. Stocks have gotten a lot pricier, and Treasuries much cheaper. The ERP has shrunk by 77% to today’s paltry 1%. The numbers tell the story: According to one of the most respected measures out there, the S&P big caps are likely providing just about the tiniest edge over Treasuries in recent times not roiled by a crisis.