4 minBusiness
Equity Risk Premium Narrows to Near Zero as Real Yields Surge
The gap between expected stock returns and inflation-protected Treasury yields has shrunk to roughly one percentage point, far below its historical average, as rising real rates make bonds unusually competitive with equities.
The extra return investors have historically earned for holding stocks instead of ultra-safe government bonds has nearly disappeared, according to a widely followed market gauge that compares the two asset classes. The equity risk premium, which measures the S&P 500's earnings yield against the inflation-adjusted yield on 10-year Treasury notes, now stands at just under 1%, a fraction of its long-term average of roughly 3.5%.
The shift reflects a sharp rise in real yields on Treasury Inflation Protected Securities, or TIPS, which hit 2.86% at midday on September 26. That marked a 110 basis point jump since early March and the highest level since the period from 1999 to 2001, when the yield generally hovered above 3.5%. The only brief exceptions in the past two decades came during the global financial crisis and the COVID-19 outbreak, when collapsing corporate earnings distorted the calculation by pushing price-to-earnings ratios to extreme highs.
On the stock side, the S&P 500's earnings yield — the inverse of its price-to-earnings ratio of 26.2 — sits at about 3.8%. For every $100 invested in the index, investors are earning roughly $3.80 in profits under standard accounting rules. For every $100 placed in 10-year TIPS, they are guaranteed about $2.86 a year above inflation. The difference, less than one dollar, represents the compensation for enduring the stock market's volatility.
The contrast with the recent past is stark. From August 2010 through December 2022, the TIPS yield averaged just 0.6%, barely above inflation. Even with a relatively expensive S&P 500 trading at a price-to-earnings ratio of 20, the index offered a 5% earnings yield, producing an equity risk premium of 4.4%. That was one of the most generous cushions over bonds ever recorded. Since then, the premium has shrunk by 77% as stocks have grown pricier and Treasuries have become far cheaper.
Kenneth French, a financial economist at Dartmouth's Tuck School of Business, has described the equity risk premium as «the holy grail of stock market investing.» It serves as a proxy for what Warren Buffett calls the margin of safety — the extra return that compensates shareholders for risk. Academic studies measuring the premium back to 1871, when economist Robert Shiller's data sets begin, put the average at roughly 3.5%, nearly four times today's level. TIPS only began trading in 1997, making earlier comparisons difficult.
The nominal 10-year Treasury yield now sits at an attractive 5.2%, giving fixed-income investors a substantial coupon with far less risk than equities. The current premium is so thin that the only comparable episodes in the past two-plus decades were brief windows during the financial crisis and the pandemic, when earnings collapsed and the metric was distorted.
For investors weighing stocks against bonds, the message is that the compensation for taking on equity risk is unusually small by historical standards. The S&P 500 may still deliver solid returns, but the gap between what stocks and government bonds are expected to provide has narrowed to a point rarely seen outside of crises.
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