The Extra Reward for Owning Stocks Over Bonds Has Disappeared
There is little sign of crimped demand for equities among individual investors, who remain bullish after two years of blockbuster gains
By Hannah Erin Lang, The Wall Street Journal, Updated Jan. 27, 2025
The equity risk premium, often defined as the gap between the S&P 500’s earnings yield and that of 10-year Treasurys (10YT), turned negative in late December for the first time since 2002 and sat last week at negative 0.15 percentage point.
The metric is based on a calculation of how much stocks yield, which is derived by dividing the stock market’s expected earnings by its price. The earnings yield is then compared with the yield on government debt.
The difference between stock and bond earnings yields shows how much investors are compensated for the additional risk of owning stocks over relatively risk-free government bonds. Over the long term, stocks need to promise a higher reward than bonds. If not, the safety of Treasurys would outweigh the risks of stocks losing some, if not all, of investors’ money… [end quote]
A bird in the hand is worth two in the bush…but a bird in the hand is worth even more if the hypothetical yield of the bird in the bush is less than one.
The yield of the 10YT is determined by the market (when the Federal Reserve isn’t suppressing it with Quantitative Easing). The yield is influenced by many factors, including the bond market’s long-term inflation expectations and the potential for supply to exceed demand due to growing federal government deficits. This chart shows that the 10 YT yield has stabilized in a channel between 4% and 5% but is still in a slowly rising trend.
https://stockcharts.com/sc3/ui/?s=%24TNX
As we all know, the SPX has risen much faster and is now in a historic bubble. The people interviewed in the article who have placed all their confidence and investments in big companies are following in the footsteps of previous bubble speculators who pay no attention to valuations.
If the 10YT yield continues to rise the value of existing bonds will fall. This risk is mitigated by avoiding bond funds and constructing a ladder of individual bonds which return par when held to maturity.
Currently, AA to AAA rated municipal debt with a maturity of 10+ years yields about 5.5%. This is a low-risk approach.
Wendy
