Stocks Havent Looked This Unattractive Since 2007

The S&P 500’s equity risk premium is currently at 1.59pp, its lowest level since October 2007. Since 2008 the mean ERP has been 3.5pp above its post 1957 mean of 1.62pp.

Eric Wallerstein, "Stocks Haven’t Looked This Unattractive Since 2007,"Wall Street Journal, April 6, 2023, https://www.wsj.com/articles/stocks-havent-looked-this-unattractive-since-2007-78fc374c

Stocks Haven’t Looked This Unattractive Since 2007

The reward for owning stocks over bonds hasn’t been this slim since before the 2008 financial crisis.

The equity risk premium—the gap between the S&P 500’s earnings yield and that of 10-year Treasurys—sits around 1.59 percentage points, a low not seen since October 2007.

That is well below the average gap of around 3.5 points since 2008. The reduction is a challenge for stocks going forward. Equities need to promise a higher reward than bonds over the long term. Otherwise, the safety of Treasurys would outweigh the risks of stocks losing some, if not all, of investors’ money.

The S&P 500 has clawed back some of last year’s 19% decline, rising 6.9% in 2023. The Bloomberg U.S. Aggregate Bond index has jumped 4.2%, boosted by an early-year rally and elevated yields.

The S&P 500 added 0.4% on Thursday after employment data pointed to the Fed gaining ground in its battle with the record-hot labor market. Bond yields edged higher.

Bonds are offering a “once in a generation opportunity, but not once in a lifetime,” said Tony DeSpirito, BlackRock Inc.’s chief investment officer of U.S. fundamental equities.

The current equity risk premium is closer to the longer-term norm: The average premium since 1957 is around 1.62 points, BlackRock research shows. That means stocks should still offer a better return than bonds given their historical outperformance, Mr. DeSpirito added.

The equity risk premium falls when bond yields rise, or a stock’s price/earnings ratio jumps—either due to weaker earnings or higher stock prices. The earnings yield, meanwhile, is the ratio of profits from the past year to current stock prices.

October 2007 would turn out to mark a precarious time in markets. Stocks had recently hit their highest level on record, and the federal-funds rate was near its current level at around 4.8%.

Over the following year, the S&P 500 would go on to drop roughly 45%, and the Fed would cut rates to near zero. Bloated stock valuations reset; bond yields cratered. By March 2009 when the stock market bottomed, stocks’ premium over Treasurys had risen above 7 points and a new bull market was born.

Stocks look pricey again today, and markets are facing a new host of challenges. By at least one valuation measure, U.S. equities are currently more expensive than those of any other country or region, Research Affiliates’ data show. That is based on the S&P 500’s price level relative to inflation-adjusted corporate earnings over the past 10 years, or the CAPE ratio. Although well off prior peaks seen in the late 1990s and 2021, the U.S. stock benchmark trades at a multiple around 29, pricier than it has been more than 90% of the time since 1881.

“We have seen the peak for stock-market valuations, but that doesn’t necessarily mean we’ve seen peak prices yet in this cycle,” said Jawad Mian, founder of macro-advisory firm Stray Reflections.

The economy is much more resilient to high interest rates than it has been in the past, said Mr. Mian. High nominal growth—boosted by inflation—will continue to support earnings more than Wall Street’s consensus currently sees, preventing a significant drop in stock prices, he said.

Analysts expect earnings among companies in the S&P 500 to edge up roughly 1.6% in 2023, according to FactSet. At the end of last year, they were calling for a 5% increase.

Since 1957, equities have beaten out fixed income more than two-thirds of the time when they were held for at least a year, BlackRock research shows. Stocks’ favorability improves as holding periods lengthen.

Focusing on stocks’ slim risk premium misses part of the picture, Mr. DeSpirito of BlackRock says. Fed intervention—suppressing short-term rates and buying up long-term bonds—created an abnormal risk-reward profile for stocks after the 2008 financial crisis. He encourages investors to seek stocks with resilient margins and strong earnings growth, while avoiding overvalued companies.

Some investors say frothy valuations mean value stocks—those trading at a discount to their book value, or net worth—warrant consideration.

Value stocks are “dirt cheap” relative to growth, now more discounted than they have been four-fifths of the time in U.S. stock-market history, according to Rob Arnott, founder and chairman of Research Affiliates.

Although value stocks trumped their growth-oriented peers during last year’s rout, growth stocks are back in the lead. The Russell 3000 Growth Index has jumped 13% in 2023, while the Russell 3000 Value Index has edged up 0.1%.

When inflation has run between 4% to 8% a year, value stocks have outperformed their growth peers by 6 to 8 percentage points annually, Mr. Arnott said. Consumer prices rose 6% in February from the year before, the smallest increase since September 2021.

“Inflation is wonderful for value,” he added.