After last week’s selloff, stock investors are nervously looking over their shoulders at the bond market, but many are unsure at what point higher interest rates start to hurt equities.
The gurus at Société Générale took a stab at calculating the magic number. Based on their analysis, a 10-year Treasury note yield TMUBMUSD10Y, -0.51% at 3.00% could knock the S&P 500 SPX, +0.39% to 2,500, a 14.5% drop from its all-time high of 2,873 from Jan. 26.
Much of their math revolves around the equity risk premium. A widely adopted valuation tool, it asks how much investors should put into stocks versus bonds based on future returns from equities. But it also helps investors ask at what threshold higher Treasury yields become attractive enough to chip away at demand for stocks.
Simply put, the risk premium reflects the spread between the stock market’s future expected returns and the so-called risk-free rate, often the 10-year Treasury note yield.
Though a low risk premium is seen in the company of elevated stock prices, on the flip side it suggests equities have less room to run higher. On the other hand, a high risk premium suggests stock investors can look forward to richer returns ahead. Plus, if the equity risk premium is already elevated it can take a knock from higher yields without falling too much.
“If the equity risk premium is high (above average), a higher bond yield can be absorbed by the equity market. However, when the equity risk premium is already very low, the equity market’s ability to absorb a higher yield is limited,” the strategists at Société Générale said.
At the moment, the equity risk premium sat at 2.8%, below the 3.9% long-term average and a level last seen during the dot-com bubble, according to Société Générale’s estimates. Assuming the risk premium remained unchanged, the S&P 500 should fall to 2,509 when the 10-year yield rose to 3.00%, as the chart below shows.
Lower equity risk premiums are often seen in the company of frothy stock valuations
Admittedly, a higher 10-year yield will rarely match the equity returns of a stock-market bull run, but it can tilt the balance toward bonds.
“Treasurys may not be as profitable in the aggregate sense, but from an active-management point of view [the 10-year yield] got a little bit interesting,” said Doug Peebles, chief investment officer at AB Fixed Income.
Treasury yields have already exceeded the average dividend yield of the S&P 500, another way investors can eyeball the relative attractiveness of government paper over stocks. The 2-year yield surpassed the S&P 500’s dividend yield in December for the first time in a decade.
The upshot is investors should rebalance their portfolios and load up on more bonds, according to the Société Générale strategists. Their recommended asset allocation has seen the equity share shrink to 50% in February from 80% in September.
Bonds are looking more appetizing
To be sure, the equity risk premium isn’t a foolproof method for predicting the path of the stock market. Like all valuation gauges, it is more of a suggestion than a prescription on where equity prices should lie.
More importantly, the equity risk premium gives money managers a useful starting point from which to make difficult decisions on how they should divvy up their money across different assets.