Fortune No Longer Favors the Brave
Anthony Summers|August 9, 2023
There’s a trade-off between risk and reward in investing.
The more risk an investment carries, the greater the return it’s supposed to offer in order to justify our investment.
That’s how markets work. Or, at least, that’s how they used to.
But the connection between risk and reward is broken. And it’s costing investors.
For proof, we turn to the equity risk premium.
While it sounds fancy, it’s a simple concept. It is the excess return that the market demands from a stock compared with a risk-free rate of return.
A risk-free investment is one that offers a virtually guaranteed rate of return. U.S. Treasurys, for example. Historically, the U.S. government has been a safe borrower.
While nothing is truly risk-free, using a benchmark like government bonds can put the stock market’s risk into a better perspective.
Here’s what I mean…
If Treasurys can offer us a risk-free rate of return, then stocks must offer a higher rate of return to justify their riskiness. The difference in these two rates of return can be viewed as the premium – or compensation – we demand for taking on stock market risk.
Below is one model of the equity risk premium that the Fed uses.
Here, the equity risk premium is shown as the difference between the S&P 500’s forward expected earnings yield – or its estimated earnings over the coming 12 months divided by total market value – and the real (inflation-adjusted) yield of the 10-year U.S. Treasury bond.
You can see that the excess return expected from stocks over government bonds has been shrinking for about a decade.
Why?
You can thank the Fed.
A decade-plus of rock-bottom interest rates has made bonds a nonstarter for most investors. While they’ve been risk-free, they’ve offered practically no reward at all.
And at many points, real interest rates on government bonds were negative.
It would’ve cost you money to invest in them.
That’s an offer everyone can refuse.
But it also left investors with no options.
It didn’t matter what stocks were expected to return… Anything was better than nothing. So investors plowed their money into stocks… no matter how much risk those stocks carried.
The thing is…
Most companies have more debt today than they did a decade ago.
And by some measures – like the Buffett Indicator – they’re more richly valued now than they were at the height of the dot-com bubble.
Of course, as long as stock returns are high enough… most folks won’t care.
But that’s a dangerous bet.
In fact, some major financial institutions have issued unsettling 10-year forecasts for stocks over the past few months. For example, Vanguard has projected stocks to return between 4% and 6% annually over the next 10 years.
Those kinds of returns won’t cut it.
And if you take inflation into account, they’re even more pathetic.
Smart investors will seek out assets whose returns justify the risks they carry…
Assets like this virtually unknown $10 stock.
Anthony Summers
Anthony Summers is the Director of Strategic Trading for Manward Press and is a contributor to Manward Financial Digest, Manward Trading Tactics and Manward Letter. He is a former senior analyst for The Oxford Club, where he closely worked with some of our nation’s sharpest financial minds for nearly a decade. Anthony is a self-styled “conservatively aggressive trader” and has earned a reputation for developing unique trading strategies that focus on low-risk, high-return opportunities in both stock and options markets.
