It is often stated that investors have become increasingly less risk averse over the past few years. This is true for many asset classes as evidenced by narrowing credit spreads and a number of sentiment indicators.
However, this is not necessarily the case with US equities, especially not when considering the valuation of equities relative to bonds.
Contrary to general perception, investors in US equities have actually become increasingly risk averse since the stock market correction of 2000/2001, at least that is the conclusion one comes to when comparing the earnings yield of the S&P 500 Index with the yield of US 10-year treasury notes.
The following graph tells the story. Where equities historically demanded a risk premium over bonds (i.e. the earnings yield was less than the bond yield), they are now trading at a relatively large discount (i.e. the earnings yield is higher than the bond yield).
As a matter of fact, a discount of this magnitude has not been seen since the period from 1973 to 1980 as illustrated by the graph below, showing the spread between the earnings yield of S&P 500 Index and the yield of US 30-year government bonds. (The 30-year bond is used as a proxy for the 10-year note used in the previous graph.)
SPREAD BETWEEN S&P 500 INDEX EARNINGS YIELD AND 30-YEAR GOVERNMENT BOND YIELD
The period from 1973 to 1980 is not unlike the current situation as it was also characterised by high oil and commodities prices. The seventies, of course, also saw commensurately high rates of inflation – a phenomenon that may yet become more prevalent this time as well.
Although the discount does not necessarily make equities cheap in absolute terms, one could argue that it should cushion the downside potential, unless of course the market is discounting a significant further rise in long bond yields.
Put another way: high bond yields are reining in the increases in equities prices. Any decline in bond yields could therefore be very positive for equity investments.
While on the topic of earnings yield, let’s also consider its relationship with the US inflation rate (as a key driver of bond yields).
In this regard it is particularly interesting to note that at all major stock market sell-offs the gap between the earnings yield of the S&P 500 Index and the US inflation rate decreased to about 1% or lower in the run-up to the sell-off. However, the graphs below show that the gap is currently 2.8%, again pointing to a cushion for equity prices.
S&P 500 INDEX EARNINGS YIELD VERSUS US INFLATION RATE (CPI)
ANNUAL CHANGE IN S&P 500 INDEX VERSUS S&P 500 INDEX EARNINGS YIELD LESS US INFLATION RATE (CPI)
While the above analysis presents only a tiny portion of the broader fundamental framework that needs to be assessed, it should provide some food for thought for the prophets of doom. As a minimum, some may consider shifting their thinking to view the market glass as being half full rather than half empty.