Why the stock market isn't paying you much right now
Add Axios as your preferred source to
see more of our stories on Google.
For the first time in years, bonds are paying a decent, after-inflation return, and that presents a challenge to the logic of owning stocks.
Why it matters: It could become a headwind for the stock market.
The big picture: At the risk of oversimplifying, all investors face a variant of this basic choice: stocks or bonds?
- One way investors decide where to put their money is by comparing the expected returns on these two cornerstone investments.
State of play: Over the last year or so, the Federal Reserve's interest rate hikes have translated into higher yields, and higher returns, for bond investors.
- Investors can now lock in a decade of real (after inflation) risk-free annual returns of almost 2% on their money, simply by buying 10-year inflation-protected Treasuries.
Be smart: Yields on inflation-protected Treasuries (also known as TIPS) serve as a key yardstick against which other investments can be measured.
- That's because these Treasury bonds are basically the closest thing investors can find to riskless investment.
- As the logic goes, because everything else is by definition riskier, those investments should pay a premium to investors for taking that risk.
The intrigue: But how high a premium do investors need?
How it works: To figure that out you need to establish some sort of "yield" for the stock market, which you can then compare to the yield on TIPS.
- Financial analysts and investors have settled on something known as the "earnings yield" of the market, as the preferred metric.
- The earnings yield is basically the inverse of the price-to-earnings ratio.
- It's a statistical fiction that reimagines the stock market as a big bond; the earnings-per-share plays the role of the bond's "yield."
Be smart: Despite the mathematical nature of this analysis, this is art, not science. There are plenty of ways to calculate and compare these numbers.
- I've calculated the earnings yield on the S&P 500, by looking at expected earnings per share of the index over the next 12 months. That gives me an earnings yield of about 5.4%.
- To get the risk premium, you then subtract the 1.9% TIPS yield from that number, giving you a 3.5 percentage point difference.
Translation: The stock market is paying you a paltry premium of just 3.5 percentage points to put your money on the stock market roller coaster, versus the sure thing of government bonds.
The bottom line: That's the most parsimonious premium markets have offered stock market investors in 20 years, since late 2003.
- And that could have big implications for the direction of the market.
