Page through any investment brochure, factsheet, or presentation, and you’ll eventually get to the disclosure language claiming “All investing involves risk.” For fixed income investors, credit spreads over risk-free U.S. treasuries provide a sense of the interest rate, reinvestment, and credit risk they assume when buying corporate bonds. Along the same lines, stock investors must consider inherent risks in the equity markets when facing investing decisions. The Equity Risk Premium (ERP) indicates the price of risk in equities and is a key metric in determining the appeal of owning stocks versus bonds or other assets at any given time.

What is ERP?

Before diving into the significance and implications of ERP, we should define what it is and how it is calculated. In general, the Equity Risk Premium is driven by macroeconomic uncertainty and general investor appetite or aversion for risk. There are several different ways to calculate or extrapolate what the current market ERP is, but for the purposes of this commentary, we aim to keep things simple by subtracting the 10-year Treasury Yield from the S&P 500 12-Month Forward Earnings Yield. In doing so, we get a general sense of what investors expect to be compensated for buying stocks.

Where Are We Today?

The chart below shows historical Corporate Bond Spreads and ERP calculations in relation to where the metric stands today. As we can see, the risk premium is close to post-Global Financial Crisis lows, even as recession risks have increased. The ERP is indicating a less attractive stock market where investors are not adequately compensated for taking on additional risk. This can be attributed to a few factors, most notably to the rise in 10-year Treasury Yields and lofty stock market valuations. As government bond yields rise, it becomes harder to justify investment in more risky stock assets. Additionally, as company valuations become richer, investors are less willing to take on the added risks of buying expensive equities.

Equity Risk Premium and Corporate Bond Spreads (Baa-UST)

One of the most interesting observations of today’s Equity Risk Premium relates to the bond market. As previously mentioned, the ERP is at a historically low level – so much so, that it is less than investment grade credit spreads over Treasuries. Effectively, investors are being paid a bigger premium to invest in bonds over stocks. If that seems odd, it’s because it is…the relationship is typically reversed.

Portfolio Implications

At Washington Crossing Advisors, we spend a lot of time assessing investment risk across our portfolios. In particular, our Conquest Asset Allocation ETF models make monthly tactical tilts based on macroeconomic inputs, including risk premiums, valuations, and corporate spreads. With the ERP at relative historic lows and high valuations, our tilts have remained neutral, favoring neither stocks nor bonds. As always, we remain vigilant to market conditions and the associated risk premiums that investors have assigned to stocks and bonds.

Kevin R. Caron, CFA
Senior Portfolio Manager
973-549-4051

Chad Morganlander
Senior Portfolio Manager
973-549-4052

Matthew Battipaglia
Portfolio Manager
973-549-4047

Steve Lerit, CFA
Senior Risk Manager
973-549-4028

Tom Serzan
Analyst
973-549-4335

Suzanne Ashley
Internal Relationship Manager
973-549-4168

Eric Needham
Director, External Sales and Marketing
312-771-6010

Jeffrey Battipaglia
Client Portfolio Manager
973-549-4031

Disclosures

The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecast in this report will be realized or achieved. Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Past performance is no guarantee of future results. Indices are unmanaged, and you cannot invest directly in an index.

Asset allocation and diversification do not ensure a profit and may not protect against loss. There are special considerations associated with international investing, including the risk of currency fluctuations and political and economic events. Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments. Investing in emerging markets may involve greater risk and volatility than investing in more developed countries. Due to their narrow focus, sector-based investments typically exhibit greater volatility. Small-company stocks are typically more volatile and carry additional risks since smaller companies generally are not as well established as larger companies. Property values can fall due to environmental, economic, or other reasons, and changes in interest rates can negatively impact the performance of real estate companies. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. High-yield bonds have greater credit risk than higher-quality bonds. Bond laddering does not assure a profit or protect against loss in a declining market. The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains. Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments.

All investments involve risk, including loss of principal, and there is no guarantee that investment objectives will be met. It is important to review your investment objectives, risk tolerance, and liquidity needs before choosing an investment style or manager. Equity investments are subject generally to market, market sector, market liquidity, issuer, and investment style risks, among other factors to varying degrees. Fixed Income investments are subject to market, market liquidity, issuer, investment style, interest rate, credit quality, and call risks, among other factors to varying degrees.

This commentary often expresses opinions about the direction of market, investment sector, and other trends. The opinions should not be considered predictions of future results. The information contained in this report is based on sources believed to be reliable, but is not guaranteed and not necessarily complete.

The securities discussed in this material were selected due to recent changes in the strategies. This selection criterion is not based on any measurement of performance of the underlying security.

Washington Crossing Advisors, LLC is a wholly-owned subsidiary and affiliated SEC Registered Investment Adviser of Stifel Financial Corp (NYSE: SF). Registration with the SEC implies no level of sophistication in investment management.