The Equity Risk Premium reached its lowest level since 2004, signaling fear in the markets.
Investors love risk, it’s a simple fact of life. Whenever investors would rather not risk in favor of safe assets, it is an objective sign of pessimism in the market. And pessimism often results in worse performances of an economy.
According to Refinitiv, the Equity Risk Premium of US stocks is at its lowest levels since 2004.
The Equity Risk Premium is a macroeconomic data obtained by subtracting the financial yield of stocks by a low-risk asset, usually the 10-years US bonds. The expected stocks yield is itself calculated using 12-months forecasts of the S&P 500 divided by its current market level.
Essentially, the Equity Risk Premium measures how much investors are willing to buy stocks compared to 10-years US bonds. While the former have an inherently risky nature, the latter are considered the safest assets on the planet. In fact, any expert in the field will probably suggest investing in US bonds only to preserve money against inflation rather than gain high returns.
Investors generally prefer investing in stocks precisely for their higher returns. Now, however, they are not attracted to risk anymore and prefer to protect their money against possible crises.
Why investors prefer bonds over stocks
When markets are dominated by optimism, investors will bet on stocks without any second thought. Though riskier, the S&P 500 is always set to grow in normal times, as its index represents the 500 best performing companies in the US.
Until one week ago, the S&P 500 was rallying, signaling overall market optimism. This growth was, however, a paper tiger and not a sign of economic well being.
The recent rally was a natural conclusion of the American Federal Reserve’s recent bank bailout, which put trillions of dollars into the economy. When, last week, the Fed signaled a withdrawal of up to $800 billion, the S&P 500 started its descent curve again.
The last time the Equity Risk Premium was so low it was before the 2008 recession caused by the housing bubble burst. Today, many experts have pointed at a similar situation, deeming a recession in 2023 virtually unavoidable.
The largest red flag and actual signal that a recession is coming will be this week’s release of GDP data in the US. If the American economy has receded in the first quarter of 2023, it will be just another quarter away from recession.
This week European GDP will also be released, allowing investors to understand how far away the EU is from recession too.
Until this data is released, the markets will be governed by fear.
