You’re getting paid nothing for risking money in the stock market, per the equity risk premium
Yeah, stocks are still on a 4% or higher earnings yield... but when bonds offer the same, what do you do?
Companies are risky. They blow up, go bankrupt, and equity holders tend to get paid last when that happens.
That’s why investors putting their money in stocks, rather than safe government bonds, have typically required a sweetener — known by some as the equity risk premium — to reward their bravery.
But that extra return has now vanished, the latest data point confirming the speculative character of the stock market at the moment.
First things first: what is the equity risk premium (ERP), exactly? It’s a method of comparing potential returns on bonds, measured in yields, with the potential return on stocks, represented by something called “earnings yields.” Earnings yields reimagine a share as a kind of bond, with expected earnings as the “yield.” If a stock costs $100 and is expected to make $4 in profit, it’s got a 4% earnings yield.
(Full disclosure: there are many variants of ERP. We’re going to use one of the most basic, subtracting the 10-year nominal Treasury yield from the earnings yield on the S&P 500.)
In theory, when earnings yields are higher than Treasury yields, that extra cushion should coax people to buy stocks. But at roughly zero, the list of reasons to buy the market, at least as far theoretical fundamentals are concerned, gets very short.
But who needs rational reasons right now! This gets at another way to think about ERP: as a gauge of investor risk appetite. As NYU professor Aswath Damodaran, the godfather of valuation geeks, explained in a recent paper, “As investors become more risk averse, equity risk premiums will climb, and as risk aversion declines, equity risk premiums will fall.”
In other words, the vanishing risk premium — along with meme stocks, options trading, outperforming unprofitable companies, and passing references to “euphoria” from Wall Street analysts — is another data point on the speculative brouhaha now unfolding.
That doesn’t mean a stock market crash is imminent. But at some point, market risk seemingly high and rewards low, the safety of bonds might start to look a little more attractive.
