If you're feeling nervous about the U.S. stock market, you have some excellent company.
Jason Voss of CFA Institute, the major professional body for money managers, said on Friday that a key indicator of market valuation was close to turning negative. "The last time that occurred?" he wrote. "Just prior to the Great Recession."
To be sure, market indicators abound, but the one that Mr. Voss is referring to has good reason to be taken seriously. It's the so-called equity risk premium, a measure of how much extra return investors expect to get from stocks compared to safe government bonds.
A fat premium indicates that potential stock buyers are demanding a big margin of safety for venturing into the risky world of equities. Investors are being cautious and conservative, and are braced for turbulence.
On the other hand, a small premium implies that shareholders are getting giddy. They are asking for little in the way of added compensation despite all the extra risks involved in holding volatile stocks rather than conservative bonds.
As a general rule, small or negative premiums suggest the market is overvalued, because investors aren't leaving themselves much of a buffer against unexpected bad news.
Financial pros have many ways to calculate the equity risk premium but Mr. Voss prefers to take a long-term view. He starts with the so-called CAPE ratio – the cyclically adjusted price-to-earnings ratio, to be more precise. It compares the current price of S&P 500 stocks to corporate earnings over the past 10 years, adjusted for inflation. The ratio is intended to remove short-term ups and downs so you can clearly see how today's stock prices compare to businesses' long-run potential to produce profits.
Mr. Voss then flips the CAPE ratio on its head to get the U.S. stock market's long-run earnings yield, a measure of how much in the way of corporate earnings an investor can reasonably expect to derive from each dollar she invests in stocks. He compares that payoff to the yield on a 10-year Treasury bond, the benchmark fixed-income investment in the United States.
All calculating aside, Mr. Voss's version of the equity risk premium offers a useful way to see whether an investor can reasonably expect to get more payoff from stocks than bonds. Right now, it's suggesting that stocks aren't looking very good at all.
By his calculations, the equity risk premium at the start of January was less than 0.52 percentage points. The last month it was so low was June, 2008, when it stood at 0.36 percentage points.
Mr. Voss, who used to co-manage the Davis Appreciation and Income Fund, isn't an alarmist. But he says the fading equity risk premium is a key reason why he's worried about the U.S. stock market, which has surged higher since the start of the year, shrinking the premium and taking it dangerously close to negative territory. The last time it dipped below zero was December, 2007, at the market peak just before the Great Recession.
"I just cannot find data to support the liftoff in share prices," he says.
Optimists can produce reasons to disagree with Mr. Voss's take. Among other things, negative equity risk premiums have been relatively common in the U.S. stock market over the past 40 years. But his preferred signal adds to a growing number of flashing yellow lights about the state of U.S. equities.
The Bull and Bear indicator compiled by Bank of America Merrill Lynch is also warning of bumps ahead. The indicator, which measures flows of money into the stock market, climbed higher this past week after investors poured a record amount of money into U.S. stock funds.
Such extreme flows are a contrary indicator, because they often go along with unsustainable valuations.
The current level of the indicator is just below a "sell" signal. It suggests a pullback of about 6 per cent is likely in coming weeks, according to analysts at the bank.