One basic principle of finance is that stocks are riskier than bonds and should therefore provide a premium return. With stocks generating annual returns of 10% and bonds 4.5%, this equity risk premium has averaged 5.5% since 1928.
Of course, the key question is what premium can be expected going forward. Answering this question requires a forecast of future returns on both asset categories. Bond returns are relatively easy to forecast because today’s yield to maturity is a relatively accurate predictor of the return that will be realized. There are many different approaches to forecasting stock returns, and even highly sophisticated models are not necessarily all that accurate. Therefore, a reasonable approach is to opt for a very simple method. The reciprocal of the P/E ratio, known as the earnings yield, is a crude estimate of future returns. So, if the P/E were currently 20, the earnings yield or simple projected return would be 5%. The projected return on 10 Year U.S. Treasury Bonds could then be subtracted from the earnings yield to estimate the equity risk premium.
This graphic displays the equity risk premium over the past twenty-five years. Note that the last observation (far right) is only very slightly positive. In fact, at 4.4%, the earnings and US Treasury yields are currently identical suggesting zero risk premium. Some analysts use P/E ratios based on one-year projected earnings, others use twelve-month trailing earnings, and still others use average earnings over the past ten years. Therefore, depending on the methodology used, you may well see modest variation in estimates of the equity risk premium. However, the message will be the same: at current prices, stocks do not seem to offer a premium return over bonds. As a point of reference, the risk premium was last zero or negative at the height of the late 1990’s Tech Bubble.
Nothing is ever clear in the investment world and even what appear to be hard and fast statistics are subject to interpretation. One implication of a low equity risk premium is that investors should be cautious because stocks are very richly priced. However, it is also possible that future earnings growth will be so rapid that today’s earnings yield materially underestimates the potential return on stocks. Still another possibility is that stocks are actually not riskier than bonds because they provide growth and inflation protection. It is quite frustrating that this analysis does not provide “the answer,” so I would simply add it to other indicators with the hope that a definitive conclusion emerges.