The dilemma of whether to invest in the stock market or invest in bonds is leaning more towards the latter than ever. At least in the United States. The increase in interest rates has caused the coupon offered by US Treasury debt to exceed 4% APR in almost all terms. In contrast, the benchmark index S&P 500 in the US has a potential return of only 5.3%. It had been 16 years since the risk premium for investing in stocks was so low.
The investment principle is based on the fact that allocating a portion of a portfolio to equities compensates because the average returns obtained are much higher than those obtained in fixed income. In the first, the biggest risk is that the value of the listed company becomes zero. In another, that the bond issuer doesn’t pay back the money and declares bankruptcy is more likely than not.
Overall, the current process of raising interest rates by the US Federal Reserve – its central bank – has put many plans on hold. The US one-year bond is giving 5.26%, 10-year 3.8% and 20-year 4.15%. With these figures, who wants the stock market among their assets?
It all depends on how much return is expected from the share investment. The historical average return of the S&P 500 has been 12% per year. However, with the slowdown in the global economy, most of the investors do not expect such good returns from the US stock market in the coming quarters.
Analysts use a metric to figure out how much the stock market will earn. They talk about return on earnings, and measure what returns are implied by comparing the latest earnings and the stock price. That measure now stands at 5.3%, but has almost always been above 6% over the past 20 years.
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Similar to the way Spain’s risk premium compares Spanish bonds with German bonds, to see how much more is being paid in this type of investment, compare the expected return in the risk premium of stocks to risk-free assets. (which in this case is a 10-year Treasury bond). And the conclusion is clear: it is not worth the risk taken.
However, the reading is not so clear. Rafael Peña, manager of Olia Neutral Fund, believes that “this is a ratio that should be monitored but it is not a signal to sell the stock market because of fundamentals but because the opportunity cost rises and the outcome pales in comparison.” becoming more flexible. expected”
In general, the perception from the market is that equities do not pay for the risk assumed, and it is better to continue to overweight the portion of the portfolio devoted to sovereign and corporate debt.
Mike Wilson, Morgan Stanley’s chief analyst, understands that Wall Street companies have already appreciated significantly this year (9.5%), a level that is not sustainable given forecasts of falling profits. Due to the economic downturn which is already starting to be felt. “The fact that the risk premium on the stock market is so low is that the market doesn’t believe that the gains are going to hold so well.”
This is how stock risk premium is calculated
- net profits, One of the financial variables used by stock market analysts is the ratio between the price of listed companies and their profits. Per (for its abbreviation in English) can be interpreted as the number of years in which the company will take to generate profit equal to the value that the investor is paying for the share price. Per 15 indicates that in 15 years the company will generate a profit to pay back the price initially paid. A high copy may mean that a company is severely overvalued or that the market believes that current earnings are too low to generate future earnings.
- potential profitability, Analysts also use the inverse of the per to analyze the potential profitability of companies. The indicator gives a measure of how expensive or cheap the stock market is in relation to the profits the companies are making.
- equity risk premium, The next step for investors is to compare the potential returns of equity with the returns offered by sovereign debt, a risk-free asset. It is not the same for a company in Germany offering a return of 30% compared to a company based in Turkey, where inflation is skyrocketing and returns on public debt exceed 20%.
The risk premium data for US equities is the lowest it has been since 2007 – with the exception of a few sessions in March, when it was also in this range of 123-130 basis points. On the other hand, the risk premium in case of European equity market is at 680 basis points.
In the European Union and other countries on the old continent, monetary policy lags behind that of the Federal Reserve (Fed), and the yields offered by bonds are not as high. The risk-free asset, the German Bund, offers a return of 2.44%, while the expected return on the Stoxx 600 index is 9.2%.
One of the results of this disparity between bonds and stocks is that a lot of money has flowed into bond funds in recent months. All recruitment records have been broken during the last few months.
Investment in corporate debt, fixed income issued by companies is also doing very well. In recent months, its premiums have skyrocketed and many multi-asset fund managers are preferring to buy bonds from companies with highest solvency. For example, Apple’s bonds are paying 6% annual coupons with minimal risk of bankruptcy.
The key to this situation is inflation. If that eases, the Fed may have room to start lowering interest rates sooner, which would lower yields on debt and send stocks higher. As long as prices keep skyrocketing, fixed income will remain attractive compared to variable income.
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