Profit watch: People cross the street in front of the US Capitol in Washington. The uncertainty swirling around markets is likely to continue. — Bloomberg
IT may seem as if Treasuries are the better bet these days with the US stock market back near record highs and government securities offering respectable yields again.
But stocks are still likely to pay more.
The urge to ditch stocks is understandable.
There’s a lot of uncertainty out there, much of which could have a direct impact on public companies, particularly around tariffs, taxes, immigration policy and deepening conflicts in energy-producing regions, most urgently Iran.
It doesn’t feel like the uncertainty is fully reflected in the elevated valuations of big US companies that drive the market.
Meanwhile, after many years of near-zero interest rates, Treasuries are finally paying an attractive yield.
Treasury yields have risen so much in recent years that some investors may now find them preferable to stocks.
One common comparison looks at Treasury yields relative to dividend yields.
By that measure, Treasuries clearly win.
Yields on Treasuries, which range from 4% to 5%, are more than three times the dividend yield for the S&P 500 Index.
It’s a crude comparison, though, because the dividend yield is only one component of stocks’ total return.
Another common but more fulsome comparison stacks up Treasury yields against stocks’ earnings yields using companies’ expected profits for the coming year.
This measure accounts for businesses’ full earnings power, not just the portion of profits they distribute to shareholders as dividends.
Even there, Treasuries compare favourably, offering yields similar to the S&P 500’s one-year forward earnings yield of 4.3% and with less risk.
But that comparison overlooks some important details, too.
For one, Treasury yields don’t account for inflation because they are based on fixed interest payments, whereas inflation is already baked into earnings yields because rising profits are driven in part by higher prices.
For comparison, inflation must be subtracted from Treasury yields or added to earnings yields.
Also, the periods for which inflation and yields are compared should line up.
When those tweaks are made, stocks have a clear edge.
One way to see that is by comparing the real yield on two-year Treasuries with the two-year forward earnings yield for the S&P 500.
The market forecast for annual inflation over the next two years is 2.5%, based on so-called breakeven inflation, a rate derived from the difference in yield between nominal and inflation-adjusted Treasuries. Subtracting that inflation forecast from the 3.9% yield on two-year Treasuries nets a yield of 1.4% after inflation.
The S&P 500, by comparison, offers an earnings yield of 4.9%, based on Wall Street analysts’ consensus earnings over the next two years.
The resulting expected premium over Treasuries of 3.5 percentage points – in finance speak, an equity risk premium – is lower than the historical average expected premium of 5.5 percentage points since 1990, but higher than investors might assume looking only at headline yields.
Of course, reality doesn’t always live up to expectations, which raises the question: Do expected equity risk premiums turn into actual premiums in investors’ pockets?
To find out, I calculated the expected two-year premiums for every month back to April 1990, the first year for which earnings estimates are available in Bloomberg data, and compared them with realised premiums two years later.
I found only a weak correlation between the two (0.28), mainly because the divergence between expected and realised premiums was often significant and noisy.
The median divergence was 3.2 percentage points during the period.
However, 82% of the time, positive expected premiums were followed by positive realised premiums.
So, stocks beat Treasuries most of the time, even if the margin turned out to be different than the one markets initially signalled.
The few exceptions were mostly around the dot-com bust in the early 2000s and the 2008 financial crisis.
For now, markets don’t seem to be showing signs of stress.
If that record is any guide, then stocks have a good chance of outpacing Treasuries over the next two years.
Unfortunately, forward earnings estimates aren’t available more than three years out, so it’s not possible to calculate a comparable, say, a five or 10-year expected equity risk premium.
But historically, the longer investors owned stocks, the more likely they were to beat Treasuries.
Still, there’s a reason it’s called an equity risk premium.
The yield on Treasuries is as sure a bet as there is in investing – and yes, that’s still true even though the United States’s finances are stretched and its debt rating was recently downgraded.
Corporate earnings, on the other hand, are guaranteed to disappoint occasionally, particularly when a crisis hits or the economy tips into recession.
While those setbacks are the exception, their timing is impossible to anticipate, which is precisely the risk investors are paid a premium to bear.
The uncertainty swirling around markets is likely to continue.
But before seeking refuge in newly resurgent Treasury yields, have a look at a thoughtfully constructed expected equity risk premium.
You might decide the risk is worth it after all. — Bloomberg
Nir Kaissar is a Bloomberg Opinion columnist covering markets. The views expressed here are the writer’s own.
