A Look at Stock Valuations Relative to Bonds

A Look at Stock Valuations Relative to Bonds

Author: Jeffrey Buchbinder, CFA, Chief Equity Strategist

Key takeaways

  • The increase in interest rates in recent months has left equity valuations more challenged.

  • Based on the Equity Risk Premium (ERP), the S&P 500 Index offers very little additional compensation for equity investors relative to fixed income, which offers some of the most attractive yields in decades.

  • The ERP is one of the primary reasons that LPL Research has a slight preference for fixed income over equities in its current recommended tactical asset allocation, but consider that valuations have not historically been good short-to-intermediate term timing tools.

  • LPL Research suggests sourcing a slight fixed income overweight from cash to maintain a neutral equities allocation relative to appropriate benchmarks.

What is the ERP?

Let’s start with the basics. We can measure the relationship between stock and bond valuations by comparing earnings yields to bond yields, giving us the so-called equity risk premium (ERP). The earnings yield is simply the inverse of the price-to-earnings ratio, which is currently at 22 based on trailing four quarters S&P 500 earnings per share (EPS).

The ERP compares the earnings yield on the S&P 500 (the inverse of the price-to-earnings ratio, or P/E) to the 10-year US Treasury yield. The inverse of 22 gives us an earnings yield for the S&P 500 of about 4.5%

We can then compare that 4.5% number to the 10-year Treasury yield (not risk free but referred to as a “risk-free rate” in the textbooks). The 10-year yield is trading at 4.11% currently, down from a recent closing high of 4.34% on August 21. Take 4.5% minus 4.11% and you get roughly 0.4%, the current ERP for the S&P 500 as shown in the chart below.

As inflation falls, policy will get more restrictive as the gap widens between the fed funds rate (upper bound) and the core deflator, the Fed’s preferred inflation metric.

Summary

Investors should get better news later this week as the job market is expected to slow and inflation rates will likely cool. As the data supports a pause in Fed policy, markets should get a little more comfortable about heading into 2024. A recession could still emerge as consumers buckle under debt burdens and excess savings dry up, but a Fed sensitive to risk management might provide the salve necessary for more risk appetite.

 

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