Buy Bonds Because Interest Rates Are High And Stocks Are Overvalued?

Starting from March this year, several finance experts have been discussing the unappealing nature of stocks due to the low equity risk premium (ERP). In simple terms, the equity risk premium represents the potential additional return achievable from investing in stocks compared to a safer, risk-free alternative.

For instance, when a government bond yields 4% while a stock yields 3%, an investor typically favors bonds due to their higher return and lower risk.

The ERP employs the 10-year government bond yield as the risk-free rate and calculates stock yields using the S&P 500's anticipated earnings yield for the next twelve months.

Earnings yield is essentially the inverse of the PE ratio. For instance, if the PE ratio is 20, the earnings yield would be 5%.

In March, Morgan Stanley released data of the ERP for the US markets, revealing that even though stocks experienced a crash in 2022 and a decline during the banking scare in February-March 2023, they remained overvalued. This is because stocks were yielding just under 2% more than government bonds, marking a two-decade low.

This situation has been created by the Federal Reserve's aggressive interest rate hike, which elevated the rate from zero to the current 5.25%. As a result, bond yields became more appealing, prompting investors to allocate their funds to capital-guaranteed bills, bonds, and fixed deposits to capitalize on the higher yields that hadn't been witnessed in the past decade.

The argument put forth was that given a marginal 1%+ difference above bond yields, it wasn't worth assuming the extra risk associated with purchasing stocks.

Surprisingly, instead of declining, the S&P 500 actually surged by 8% over the past six months. This raises the question: if stocks are indeed unattractive, why are their prices rising and who is buying them?

Consequently, I find the ERP model less valuable in assessing whether one should steer clear of the stock market, as its effectiveness has been limited.

Now, let's delve into the potential shortcomings.

Firstly, not everyone acts rationally. Economics has struggled to accurately replicate the real world due to the inherent unpredictability of human behavior. Not all individuals adhere to the ERP concept. For instance, I am one who doesn't. Despite rising yields, I've consistently favored stocks over bonds, driven by my view in superior long-term stock returns.

Investors who opt for bonds over stocks are likely inherently risk-averse and might not have initially been involved in the stock market. They could have kept their funds in bank accounts and subsequently decided to leverage higher yielding bills, bonds, or fixed deposits as interest rates escalated. Consequently, they are not actively "selling stocks" and contributing to a stock market decline, given they never held stocks to begin with.

Secondly, a low ERP doesn't necessarily forecast a downturn in the stock market.

By analyzing a similar historical chart over a more extended period, it becomes evident that the ERP of 11% in 1979 gradually dwindled to nearly zero in 2000. This implies that stocks remained bullish despite ERP alerting investors about stocks were getting expensive over the span of 21 years. This challenges the efficacy of using ERP as a gauge of stock overvaluation during that era.

This also implies that today's low ERP can further decline, causing stocks to appear more expensive than bonds than ever before, and yet, stock prices can continue to go up.

I suggest a more effective utilization of the ERP. Instead of fixating on the yield spread, one should focus on the trend.

If the ERP is on a downward trajectory, it's an opportune time to invest in stocks rather than avoid them. This is because the stocks are outperforming bonds and are likely to continue, given that ERP trends often persist for many years.

Conversely, if the ERP is trending up, it is better to go with bonds. This was the case between 2000 till 2012 as indicated by the second chart. Indeed, the US stocks were going nowhere and one would have avoided the 2008 Great Financial Crisis and come out ahead with bonds. Thereafter the signal was to switch to stocks in 2012 and one would have enjoyed a great bull run for the subsequent decade.

Presently, the yield spread is trending downward, reinforcing my decision to favor stocks over bonds.