The gap between the 12-month forward earnings yield on the S&P 500 and the 10-year U.S. Treasury note has plunged to less than 100 basis points as of the start of this week. That’s a two-decade low, and the implications are enormous.
This difference, also called the equity risk premium, helps decipher how expensive equities are vis-à-vis government bonds. The lower the premium, the lower the margin of safety in stocks – ergo underperformance in equities versus debt over a 12-month horizon. The last time the equity risk premium shrank to a level this low – and even lower – was during the dot-com bubble, when the overvalued S&P 500 hit a high of 1,527 in March, 2000, only to correct by 49 per cent to 777 over the next two years.
One of the first questions that comes to an investor’s mind is, what would mean reversion imply in this case? We ran a few scenarios to see what it would take to regress to the 20-year average of 3.3 per cent, or to an average of 2.5 per cent if we were to include dot-com era lows (outliers, in our opinion).
In either case, we are far from the average levels. In order to revert to the two-decade average of 3.3 per cent, the 10-year U.S. T-note yield would need to plunge all the way to 1.5 per cent (assuming S&P 500 price and earnings expectations hold constant) or to 2.5 per cent if we include dot-com lows. Currently, it’s hovering near 4 per cent.
Alternatively, earnings per share would have to go up to US$320 (about a 46-per-cent increase), or the S&P 500 price would have to correct down to the 3,000 level, all other things being equal. On Wednesday, the S&P 500 was near 4,500.
In a world driven by investor emotions and the U.S. Federal Reserve’s actions, we expect it to be a combination of a pullback in Treasury yields and a price correction in the S&P 500.
To further estimate expected returns in these scenarios, we back-tested for forward-looking returns by S&P 500 and Treasury notes consistent with different levels of the equity risk premium.
At the current level of risk premiums – with the equity risk premium set at between zero and 1 per cent – the Bloomberg U.S. Treasury index has generated an average 12-month forward positive return of roughly 13 per cent and has been up 100 per cent of the time over the past 20 years. Even if we were to include history between 1997 and 2002 (dot-com boom and bust), Treasury market returns have averaged almost 7 per cent in the ensuing 12 months and provided positive returns almost 80 per cent of the time. The equity market performance, on the other hand, has been dismal, with an average 2.3-per-cent down move and positive returns seen only 26 per cent of the time in the past two decades. The numbers don’t change much with or without the inclusion of the dot-com bubble and bust in the early 2000s.
Bottom line: Mean reversion of the equity risk premium tells us that both bond yields and equity prices need to adjust lower in the coming months, quarters and maybe even years. This means asset allocators should be taking profits in the overpriced equity market and placing the proceeds in oversold Treasury notes and bonds.
David Rosenberg is the founder of Rosenberg Research and the author of the daily economic report Breakfast with Dave. Bhawana Chhabra is senior market strategist with the firm.
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