Mondial Dubai - Chart Of The Week

Is the juice worth the squeeze?


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What does the chart show?
 
This chart shows the S&P 500 earnings yield compared to the yield on 10-year US Treasuries since 2010 as a way of measuring the Equity Risk Premium (ERP) over time. The S&P 500 earnings yield gauges the earnings generated by index constituents relative to the index’s current price. When earnings yields are low compared to historical values, this suggests equity markets are overvalued as earnings are not keeping up with price gains, the reciprocal of the Price/Earnings (PE) ratio. A popular way for investors to measure ERP is to compare this to the yield on 10-year US Treasuries - the additional return investors are compensated with for taking on higher risk relative to risk-free assets. For investors, this can show the relative attractiveness of stocks compared to bonds and determine allocation weights between asset classes in portfolios. As shown in the chart, the ERP for the S&P 500 (illustrated by the gap between the two yields), is currently at its lowest point in 12 years, since 2007.

 Why is this important?

 The S&P 500 has experienced a significant surge in 2023, and valuations have outpaced earnings growth. Consequently, there has been a decline in the broad market’s earnings yield, indicating a potential overvaluation of these equities. With valuations so stretched against a backdrop of recession risks and a potential downturn in company earnings, the uncertain economic climate does not seem to be factored into markets. On the other hand, Treasury yields have spiked following numerous rate hikes by the Federal Reserve, and with inflation figures cooling, markets now predict we are nearing peak rates. However, some investors argue that ERPs are no longer comparable to historical levels, asserting that current equity valuations are justified given the recent advancements in technology. Optimists foresee these developments will lead to increased productivity, and consequently the higher earnings potential of companies. Furthermore, following the recent debate surrounding the quality of US credit, questions have been raised regarding whether US Treasuries can still be used as a benchmark for risk-free assets. Albeit that most investors still view US government bonds as the cornerstone of multi-asset portfolios, which provide a safe haven in times of economic uncertainty. Regardless, investors need to determine whether the ERP is worthwhile when investing in US equities - where valuations are arguably stretched - given the real yields that US treasuries are offering today.

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Mondial Dubai - Chart Of The WeekBy Mondial Dubai