US stocks are the most expensive in decades

Try a little and you will see that it is not at all difficult to argue that the stock market looks risky and that a crash is imminent. But in the long run, such arguments are usually best ignored. Since 1900, US stocks have shown an average real return of 6.4% per year. Over three decades, this would transform the purchasing power of $1,000 into $6,400. Bonds, the main alternative, aren’t even close. With an average historical return of 1.7% per year, they would generate a ridiculous $1,700. Cash would be even worse.

The lesson for today’s investors, many of whom have been surprised by this year’s bull market, may seem simple. Forget about the downturn that may or may not materialize. Just buy and hold stocks and wait for income to wipe out any short-term declines. Unfortunately, there is a catch. What matters today is not historical returns, but future returns. And by that measure, stocks currently look more expensive — and therefore lower in future income — relative to bonds than they have been in decades.

Why stocks usually outperform bonds

Start with why stocks typically outperform bonds. Stock is a right to a company’s earnings that stretches into the future, making income inherently uncertain. A bond, on the other hand, is a promise to pay a fixed stream of interest payments and then repay the principal. The borrower may go bankrupt; changes in interest rates or inflation may change the value of the cash flows. But the stock is the riskier option, which means it should offer a higher return. The difference between the two is the “equity risk premium” – the 4.7 percentage points per year that stocks have historically earned over bonds.

What will it be like in the next few years? Estimating a bond’s yield is easy: it’s simply its yield to maturity. Estimating the return on a stock is more difficult, but a quick indicator is given by the “earnings yield” (or expected earnings for the coming year divided by the share price). Combine the two benchmarks of 10-year Treasuries and the S&P 500, and you have a rough measure of equity risk premium that looks forward, not backward. In the past year, it has failed.

Consider now the variable parts of the stock risk premium: earnings, bond yields, and stock prices. Both expected earnings and bond yields are about where they were in October, when stocks bottomed. But since then, stocks have risen a lot, reducing their earnings yield and bringing it closer to the “safe” yield of government securities. This can mean three things. Investors may believe that earnings will soon begin to grow rapidly, perhaps because of an artificial intelligence-driven manufacturing boom. They may think that profits have become less likely to disappoint, justifying a lower risk premium. Or perhaps they fear that bonds, the benchmark against which stocks are measured, have become riskier.

Steady earnings growth is the ideal scenario. The second option, however, is darker: investors have allowed their reborn spirits to overtake them. Ed Cole of the Man Group, an asset manager, argued that the lower risk premium on stocks was a bet for a “soft landing”, where central bankers lower inflation without a recession. This is becoming easier to imagine as price increases have cooled and most countries have so far avoided downturns. However, surveys of manufacturers still point to a recession in this sector and the full tightening effect of the rate hike may not yet be felt.

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