Over the last year or two we have heard many times that stocks are too cheap because the Risk Premium put on them by the market is too high. Stocks kept rallying but the so called "risk premium" seemed to barely move and the talk of a cheap stock market seemed to stay even as we reached all-time highs in the indexes. How is this possible?
You can define the S&P 500 risk premium as the difference between the earnings yield (i.e. what companies earn a year in terms of percentage) and what you would get for a Treasury bond with a maturity of 10 years or more (let's assume a 10yr bond for now).
Now we can understand why the risk premium is still there. Even as the S&P 500 has rallied a lot over the last 3 years, the Fed has pushed yields on treasury bonds lower and lower until we touched 1.7% a few months ago. One rule of thumb usually says the S&P 500 yield has to match the 10yr treasury yield for stocks to be fair. I don't subscribe to any rule of thumbs or any other over-simplistic dumb rules, but it does have a point.
The earnings yield of the S&P 500 is around 6% for now, while the 10yr T-Bond yields 2%, the difference being 400 basis points. So one or the other has to give a little more to get that differential closer to shape.
Our thought so far had been with stocks, but now stocks have rallied more than enough. We think first that earnings will stay flat and perhaps contract a little bit. There has been too much spare capacity in every industry from commodities to house building to industry machinery, you name it. As the money base grew and the economy picked up, many companies got caught off-guard and didn't have the means to quickly raise production. This leads to some short to medium term spike in prices which then translate into higher earnings. Then higher prices bring increased production, as there is still lots of spare capacity but it takes a few months to start it back up. That will in turn bring more competition, more supply, and softness in prices, as we already have experienced in commodities.
But our biggest bet is for Treasury yield to slowly but steadily move back up, and bonds back down. And now that the Fed finally is contemplating no more QE (even if it happens in 2 years), the confidence for such a bet has increased to make it one of the main macro trades. Best bet - TBF, TBT or TTT depending on 1x, 2x or 2x exposure. Sure you will lose 2.5%+ a year if nothing happens (you pay the 2.5% coupon yield to the long-side of the equation), but if you're long stocks, then it's just more than a natural hedge at this point.
Disclosure: I am long TTT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.