Stocks Now Yield Less Than Treasuries, and That Has Not Been True for Twenty Years

The S&P 500 traded at 19.2 times its expected earnings for the next twelve months as of September 25. Invert that and you get an earnings yield of 5.21%, which is what the index earns per dollar of price. The ten-year Treasury closed the same week at 5.26%.

So the earnings yield on American equities is now slightly below the yield on a government bond with no credit risk. The gap between them, which investors call the equity risk premium, has gone from positive to roughly zero, and for a brief stretch negative.

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What the premium is meant to pay for

Owning a share means accepting that earnings can fall, that dividends can be cut, that the company can fail, and that the price can halve in a year for reasons nobody predicted. Historically investors demanded compensation for all of that in the form of a higher yield than a Treasury offered. That compensation is the equity risk premium, and across most of the past two decades it has been positive by two to four percentage points.

It is close to zero now, and this has happened without stocks becoming obviously expensive by their own standards. A forward multiple of 19.2 sits below the five-year average of 19.8 and only just above the ten-year average of 19.0. The market has not re-rated upward. The risk-free alternative has re-rated underneath it.

That distinction matters because it changes what would fix the situation. If equities were expensive, a correction would restore the premium. Here, either earnings have to keep growing fast enough to lift the earnings yield, or the ten-year has to come down.

The last time this happened

Whitmore's Watchlist:
VYM (Vanguard High Dividend Yield ETF): Large caps paying an actual cash yield, the equity answer to a competing bond coupon.
COWZ (Pacer US Cash Cows 100 ETF): Screens the index by free cash flow yield rather than by earnings.
SPLV (Invesco S&P 500 Low Volatility ETF): The same market with the drawdown profile that a thin risk premium makes harder to justify.

A zero or negative equity risk premium was the normal condition before 2002. Through the late 1990s, bonds yielded more than stocks earned and equities still rose for years, because the earnings kept coming. It ended badly, but it ended years after the signal first appeared, which is the practical lesson: this is a statement about expected long-run return, not a timing indicator.

What it does reliably predict is how the next disappointment gets priced. When the premium is wide, a bad earnings quarter is cushioned by the cheapness that was already there. When it is zero, there is nothing beneath the price except the growth assumption, and the market has to reprice the whole assumption rather than trim it.

The growth assumption here is unusually specific. Third quarter earnings are expected to grow 29.1% against last year, on 12.1% revenue growth, which would be a third consecutive quarter above 25%. Those numbers depend heavily on energy and semiconductors. Analysts' bottom-up target for the index is 9,275 against roughly 7,700 today.

What actually follows from it

The useful response is not to sell equities because a ratio crossed zero. It is to be honest about what the index is now offering, which is the return on corporate earnings growth and nothing else, because the valuation cushion and the yield advantage have both been spent.

That reframes some ordinary decisions. A retiree deciding between an income portfolio and a bond ladder is now being offered more certain cash from the ladder. An investor rebalancing into equities after a rally is buying a lower prospective return than the same allocation offered two years ago. Neither observation requires a market call.

It also raises the value of things that sit between the two. Free cash flow yield, dividend growth, and the parts of the market whose earnings are not levered to two sectors all become more interesting when the index-level premium has disappeared.

Whitmore's Take: With the earnings yield at the ten-year yield, equities are no longer being paid for their risk at the index level. Worth deciding whether you own the index for the growth story, because right now that is the entire case.

Disclaimer
The content in this email does not constitute an offer or solicitation to buy or sell any financial instrument. All commentary is general in nature and is not directed at any individual investor.

Written by Daniel Whitmore
Millionaire Insiders