Buying stocks today just isn’t worth the risk, say these analysts. They have a better opportunity for you to earn returns of up to 5%.

After being dismissed as irrelevant for much of the past decade, the equity risk premium has fallen to its lowest level since 2007.

For some, this means US stocks are no longer worth the risk, as investors can earn returns of 5% or more by buying short-dated Treasuries and other high-quality bonds.

In the years after the financial crisis, many investors ignored the ERP as US stocks steadily rose higher and their valuations were supported by the Federal Reserve-imposed interest rate floor.

Some investors had a name for this phenomenon: TINA, which stands for “There Is No Alternative” – ​​meaning that with bond yields so low, investors were highly motivated to put their money in the stock market.

Now the situation has reversed. As inflation and expectations of a tougher economic environment weigh on corporate earnings expectations, the near-guaranteed returns that Treasuries offer have skyrocketed. This means that the equity risk premium is finding its way back into use as a measure of the relative value of stocks, as it can provide helpful insights into what investors can gain in the short term by taking on the additional risk that comes with buying or investing in equity funds .

The methods for calculating the ERP vary. Some economists like to include measures of inflation in their calculations to find what is called the “real” equity risk premium (“real” in this case means the figure is adjusted for inflation subtracted from the bond yields used in the equation). .

How to calculate the equity risk premium

Others simply use analysts’ projections of how much earnings S&P 500 companies are likely to make over the next 12 months.

As of Friday’s close, the equity risk premium was 1.7%, according to FactSet data.

Investors can arrive at this number by taking next year’s projected Wall Street earnings per share for the S&P 500 — in this case, $221.68 according to FactSet data — and dividing it by the S&P 500 level , which was around 3,970 As as of Friday’s close. The result is multiplied by 100 and gives approximately 5.6%. Investors then subtract the current risk-free rate — in this case, the 10-year Treasury yield of 3.920% — to get the final figure.

“It’s not that much,” said Liz Young, head of investment strategy at SoFi, who spoke to MarketWatch after sharing a chart of the ERP on Twitter.

“Basically it’s telling you that you’re paying a lot for that level of risk,” Young said, referring to US stocks. “It’s not a good entry point for many different reasons.”

What does this mean for the market?

While a low ERP could be good news for bonds, it could also mean investors willing to wait out the commotion could walk away with a good deal. That’s because a low ERP has historically been correlated with recessions and bear markets, according to former New York Fed economist Fernando Duarte, writing about ERP in a 2015 article a New York Fed blog post from December 2020.

Although the US economy is not in recession as US GDP growth remains robust, the S&P 500 entered the bear market over the past year. The large-cap index is still down about 17% from 4,796.56, its all-time high hit on Jan. 3, 2022, according to FactSet.

Meanwhile, investors looking to outperform the broader market need to be more critical when deciding which stocks to buy. Young and others expect companies with robust business models, low levels of debt, and the ability to generate cash even when the economy is trembling to prevail.

“Knowing how certain companies are making their earnings and how resilient those earnings or cash flows are going to be critical,” said Callie Cox, US investment analyst at eToro during a phone interview with MarketWatch.

Steve Eisman, the former hedge fund portfolio manager who rose to fame thanks to The Big Short, said Monday that he was buying bonds “for the first time in a long time.” While tech stocks have led a market recovery since the beginning of the year, Eisman believes the days of banks generating superior returns by investing in tech stocks are over.

US stocks rebounded after suffering their biggest weekly decline of the year on Friday. The S&P 500 SPX,
It closed 0.3% higher on Monday after ending the week down 2.7% on Friday, according to FactSet data. The Dow Jones Industrial Average DJIA,
gained 72.17 points or 0.2%.

Meanwhile, government bond yields declined slightly, but the 10-year yield TMUBMUSD10Y,
is still on the verge of climbing above 4% for the first time since last fall. It fell back to 3.921% on Monday, down 2.7 basis points on the day. Buying stocks today just isn’t worth the risk, say these analysts. They have a better opportunity for you to earn returns of up to 5%.

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