At current levels, investors can garner a four-per-cent yield on the two-year T-note, or more than 3.5 per cent on the 10-year. In comparison to bonds, the stock market is back to its least attractive since late 2007, with the additional compensation for risk at just 270 basis points.
Interestingly enough, after initially expanding following the market peak on Jan. 3, the risk premium began to significantly contract 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 .
Our work shows that a trough is not put in until the ERP widens by 425 basis points. More importantly, while the range varies from +137 basis points to as much as +623 basis points, no bear market has bottomed without an ERP that has expanded at all. Even at the mid-June lows, the increase in the equity risk premium was a lowly 30 basis points, to just over 300 basis points.
For illustrative purposes, if we assume an equal split in terms of contribution from stocks and Treasuries towards an expanding ERP, achieving a +425-basis point change translates to a fall in the 10-year U.S. Treasury yield towards 1.5 per cent alongside an approximately 20 per cent drop in the S&P 500 from current levels. Should interest rates prove more resilient, stocks would have to fall even more.