Are Stocks Offering “Return-Free Risk”?

Stock investors are getting a bad deal today … we’re nearing a negative equity risk premium … bets that yields will climb … election risk is rising

The S&P 500 is up 21% so far in 2024.

But this fantastic performance has shifted the risk/reward profile of investing new money at today’s prices. In fact, investors are accepting an absurd amount of risk when they buy the average stock today.

But don’t take my word for it. Let’s go over a few numbers together and you decide.

To set the stage for our analysis, remember: stocks aren’t the only game in town.

There are bonds, real estate, cryptos, private equity deals, foreign assets, commodities, you name it. At the end of the day, what’s important to investors is receiving the highest risk-adjusted return, or yield.

For our purposes today, we can rephrase this as “after the blistering bull market that began two years ago, how attractive are stocks as an asset class, relative to risk-free treasuries?”

We answer this by calculating the equity risk premium (ERP)

The ERP shows us how much extra return stock investors are demanding beyond the return they can get from risk-free investments (U.S. bonds).

Comparing the size of today’s ERP to its long-term average gives us a sense for whether stocks are offering us a good relative deal today.

To do this, we start with the yield of our risk-free asset, which is the 10-year Treasury note. If you haven’t been watching, the 10-year yield has been surging in recent weeks as traders worry about reinflation and the potential for a slower pace of rate cuts from the Fed.

As I write Wednesday mid-morning, the 10-year yields 4.24%. In mid-September, it traded as low as 3.59%. That’s a major jump in only a handful of weeks.

Next, let’s figure out the overall yield from the S&P.

We start with the S&P’s earnings yield. This is just the inverse of its price-to-earnings (PE) ratio. According to Multpl.com, the S&P’s PE ratio is 29.87. So, when we divide “1” by “29.87” that gives us 3.35%.

Now, let’s factor in dividends. According to Multpl.com, the S&P’s current dividend yield is 1.25%.

Combining the S&P’s earnings yield and dividend yield gives us a total yield 4.60%.

So, we have two choices: the 10-year Treasury note yielding 4.24% or the S&P yielding 4.60%

The difference between them – just 36 basis points – is today’s ERP. And without any further analysis, it should stop you in your tracks.

It’s telling us that on a straight-up, head-to-head battle, investors are willing to accept close to zero additional return firepower than bonds at today’s valuations.

Stated another way, you can buy a 10-year Treasury yielding 4.24% and take on zero risk of losing your money (if you hold to maturity, and assuming the government doesn’t implode between now and your maturity date) …

Or you can buy the S&P that’s offering you a meager 36 basis points more…and expose your wealth to today’s nosebleed market valuation… the potential for presidential election chaos… our government’s reckless spending… and any other source of downward volatility you want to include.

But let’s keep going.

As I just noted, at face value, stocks have the slightest of edges because they yield 36 basis points more than bonds. But remember, this isn’t an apples-to-apples comparison because the risk levels aren’t the same.

The way to analyze this differential in risk, and what that means about the attractiveness of stocks, is by comparing our current ERP to the long-term average ERP.

And where does that value come in?

Well, though it bounces around, the long-term average ERP is roughly 3.68%, or almost 1,000% larger than today’s ERP.

Inverting this ratio for a different perspective, today’s anemic ERP is offering investors less than 10% of the average premium they usually receive for taking the risk of buying stocks over bonds.

That doesn’t sound like a good deal.

But it’s not just that…

At just 0.36%, today’s ERP is close to being negative

Here’s Global Financial Data with some perspective:

The equity-risk premium (ERP) is one of the most important variables in finance.

In theory, riskier stocks should provide a higher return than risk-free government bonds, but unfortunately, this is not always true…

Although stocks are riskier than bonds, there are 17 periods during the past 100 years when the equity-risk premium was negative, meaning that bonds outperformed stocks over a 10-year period…

A positive ERP is not a given. The other primary period when the ERP was negative [beyond the post-World War I era] was the 2000s when bond yields were high, and the stock market faced two dramatic declines in 2000 and 2008 during the Great Financial Crisis.

It’s never a good thing when your current market environment is comparable to those in 2000 and 2008.

But let’s be clear, I’m not saying bail on your portfolio, or even stop buying stocks when you see compelling opportunities. But this data should serve as an investment smelling salt, jolting you back to awareness so that you have clear eyes about what’s happening.

But Jeff, the ERP isn’t negative yet. And even though the 10-year Treasury yield is up in recent days, it’s going to be headed lower as the Fed keeps cutting rates.”

Well, yes, that’s the narrative many investors are subscribing to today.

But if you’re in that camp, be aware that you’re betting against perhaps the greatest trader of all time, Stanley Druckenmiller.

For newer Digest readers, “the Druck” is a market legend. He’s credited alongside George Soros as “breaking the Bank of England” when the two made $1 billion from shorting the pound. He has perhaps the best long-term investment track record of any investor alive.

From MarketWatch at the start of the month:

Stanley Druckenmiller is shorting U.S. bonds…

He said he did not know whether the bond trade would take six months or six years to play out. It’s not clear how Druckenmiller is shorting bonds and over what maturity.

Despite the lack of specifics, the Druck’s baseline bet is that bond yields will rise (a “short” means Druck is betting bond prices will fall, which means bond yields will climb). And if that happens while the S&P’s overall yield remains constant, voila, you have a negative ERP.

But wait – with the Fed cutting rates and inflation falling from two years ago, why is Druckenmiller betting on higher yields? Wouldn’t lower yields be logical?

I’ll give you a hint relating to one of his reasons…

Tuesday, November 5th

Let’s go back to Druckenmiller:

I will not vote for Kamala Harris and I will not vote for Donald Trump. Bipartisan fiscal recklessness is on the horizon.

The famous investor believes that whoever wins in November is going to blow out spending, resulting in a resurgence of inflation not seen since the 1970s.

Back to MarketWatch:

The former hedge fund manager, who built his career managing George Soros’ Quantum Funds, also said his ex-boss “would be embarrassed” of him failing to make a bigger short bet on U.S. bonds, as he suggested inflation could now surge to levels last seen in the 1970s. 

Druckenmiller isn’t alone in worrying about our nation’s financial condition and what that means for the investment markets, regardless of who is president. Yesterday, another legendary investor, Paul Tudor Jones, sounded off.

Here’s CNBC:

Billionaire hedge fund manager Paul Tudor Jones is raising alarms about the U.S. government’s current fiscal deficit and the increased spending promised by both presidential candidates, saying the bond market may force the government’s hand after the election in addressing it.

“We’re going to be broke really quickly unless we get serious about dealing with our spending issues,” Jones told CNBC’s Andrew Ross Sorkin on Tuesday…

[Jones] said he was worried that the government spending could cause a big sell-off in the bond market, spiking interest rates…

“The question is after this election will we have a Minsky moment here in the United States and U.S. debt markets?” Jones said, referring to shorthand for a dramatic decline in asset prices.

“Will we have a Minsky moment where all of a sudden there’s a point of recognition that what they’re talking about is fiscally impossible, financially impossible?,” he continued. It’s an important question…and it’s the question that legendary investor Louis Navellier and our geopolitical expert Charles Sizemore have been asking…

What will the day after the election – November 6th – bring?

Well, there’s a great likelihood that it won’t bring a clear presidential winner due to the need to count mail-in ballots.

Even if it does, will that winner be contested? Will we see mass protests and/or a refusal to accept the outcome?

On Wall Street, we’re likely to see a massive redirect of investment capital as traders funnel money into whatever positions they believe best reflect the new president’s economic policies. While that means heavy buying in some sectors, the flip side is massive selling in others.

The market overhangs here are plentiful and significant.

Next Tuesday, Louis and Charles are sitting down to map out how they’re preparing for “day after” concerns like these, as well as what they believe is in store for the investment markets.

Please recognize that this isn’t just a casual, high-level chat without any real substance. Regular Digest readers know that it was nearly one year ago (last November) that Louis and Charles sat down and made a huge prediction – Joe Biden would be replaced on the presidential ballot. Obviously, that’s exactly what happened.

I’m told their latest prediction will take many investors by surprise yet again. Here’s Louis:

Most folks are simply preparing for a repeat of the contested election results of 2020. The truth is unlike anything you’re prepared for…

In the early hours of November 6th — the day after the election — we’re predicting that uncertainty and political strife will begin… 

The day AFTER the election will be a critical date that could cause stock market chaos for everyday investors.

We’ll bring you more on this between now and next Tuesday, but to go ahead and reserve your seat for this important conversation and market analysis, click here.

Coming full circle…

At the top of today’s Digest, I wrote that we’d walk through the numbers together so that you can decide for yourself…

So, what’s your take?

Does today’s barely positive ERP lead you to believe that now is a great time to buy the average stock?

What about when we factor in the risk of election volatility? Or include government spending and inflation risk? Or recall the warnings from Druckenmiller and Jones?

If any of this gives you pause, join Louis and Charles next week to get their perspective and related market action steps.

More on this to come…

Have a good evening,

Jeff Remsburg