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For years, investors maintained a bullish view on the equity risk premium (ERP) in the United States, claiming that the low levels of bond yields made the stock market more attractive in comparison and that “there is no alternative.”

Well, this narrative has completely evaporated with the rise in bond yields. The S&P 500 is hovering at levels that are the least attractive, relative to Treasuries, they have been since 2007.

The ERP is, put simply, a measure of how much extra return investors expect to get from stocks compared with safe government bonds. A high premium means potential stock investors are being cautious and demanding a large margin of safety for buying equities. A small premium indicates an overvalued market because they are asking for less in the way of added compensation for venturing into the riskier world of stocks.

With U.S. stocks in the midst of a 16-per-cent-plus correction, it would be prudent to look back in history to see how far the ERP would need to widen before investors can begin to feel confident that a bottom is nearing. Unfortunately for the bulls, there is considerable room to go still on this front, with the risk premium actually compressing, despite the sell-off.

The equity risk premium is currently just 300 basis points. Prior recessionary bear markets did not end until levels widened, on average, to 425 basis points. (There are 100 basis points in a percentage point.)

Interestingly enough, after initially expanding following the market peak back on Jan. 3, the risk premium actually began to contract significantly as the surge in bond yields dwarfed the improvement in the S&P 500 earnings yield. (Note that our definition of the ERP is calculated by subtracting the 10-year Treasury yield from the S&P 500′s forward earnings yield, also known as the Fed Model.)

While this narrowing process has reversed somewhat in recent days, thanks to 10-year yields appearing to stabilize, all that has been achieved is bringing the ERP back to the level it was at the S&P 500 peak at the beginning of the year.

What is clear is not only how unusual this sell-off period has been, historically, but also how much work needs to be done for the ERP to get caught up.

No bear market has bottomed based on an ERP that did not widen at all, or as was the case a few days ago, still contracting.

Ultimately, it is evident that this corrective phase has followed a different pattern than similar periods in the past – no thanks to the current inflationary pressures and the upward influence on bond yields.

That said, while there are multiple moving parts to how the ERP can normalize, it is unlikely that the stock market will be unscathed. Either bond yields significantly fall, thanks to aggressive central bankers getting the recession needed to reset supply/demand conditions (thus weighing on profits and flowing through to stock prices), or equity valuations will have to fall significantly faster than they have currently to outpace the rise in yield.

As an extreme example, holding bond yields steady to illustrate, to get the 425-basis point historical average increase in the ERP to mark a stock market bottom, the S&P 500 would have to decline a whopping 40 per cent from current levels. If we are to assume an equal split, in terms of contribution from stocks and Treasuries toward an expanding ERP, then it assumes a fall in the 10-year U.S. Treasury yield to 1 per cent alongside a 25-per-cent drop in the S&P 500 from current levels.

To us, the path of least resistance for equities is likely to remain to the downside – what has happened with the ERP to date is simply insufficient to call a bottom just yet. Meaning now is not the time to jump into the stock market despite the correction to-date, even as the probability grows of lower yields ahead.

David Rosenberg is founder and president of Rosenberg Research. Marius Jongstra is senior economist and strategist

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