Historically, stocks have offered a big premium over bonds. Suddenly, the difference has almost vanished

Historically, stocks have given a significant advantage over bonds, but this advantage has recently shrunk dramatically. A key metric measuring the potential returns investors can expect from stocks versus the safety of holding 10-year Treasury notes is called the Equity Risk Premium (ERP). This metric estimates the future returns from the S&P 500 compared to the risk involved in holding government bonds.

Kenneth French, a renowned financial economist from Dartmouth's Tuck School of Business, described the ERP as "the holy grail of stock market investing." To calculate the ERP, one needs to compare the S&P 500's earnings yield with the "real" or inflation-adjusted yield on 10-year Treasury notes. For every $100 invested in the S&P 500, investors receive about $3.80 in earnings.

For every $100 in 10-year TIPS, they are guaranteed about $2.86 a year above inflation. However, the difference between these two figures, which used to be a substantial reward for weathering the stock market's ups and downs, has now shrunk to less than $1. This slim 1% premium for investing in stocks compared to bonds is the lowest it has been in the past two decades.

The sudden rise in real interest rates has significantly reduced the ERP. On September 26, the 10-year TIPS yield jumped to 2.86%, a 110 basis point increase since early March. This represents the highest level since the yield generally hovered above 3.5% from 1999 to 2001, except for brief periods during the Global Financial Crisis when it surged slightly above today's number amid widespread panic.

The earnings yield, which is the inverse of the S&P PE ratio of 26.2, is 3.8%. With the current 2.86% TIPS yield, the ERP now stands at just under 1% (3.8% minus 2.86%). This reduced ERP level has only been seen a few times in the past two and a half decades, during the Global Financial Crisis and the COVID outbreak, when earnings collapsed.

Historically, the average ERP has been around 3.5%, almost four times the current level. Since TIPS trading began in 1997, it's challenging to determine the ERP for earlier periods. In recent decades, the ERP has been boosted by exceptionally low real rates. From August 2010 to December 2022, the TIPS yield averaged just 0.6%, barely above inflation.

Despite stocks being relatively pricey with a 20 PE ratio, they still offered a compelling 5% earnings yield compared to the 0.6% TIPS yield, which provided an ERP of 4.4%. However, since then, stocks have become significantly pricier, and Treasuries much cheaper, leading to a 77% decrease in the ERP to its current meager 1%.