Key Takeaways:
The equity risk premium for US stocks has collapsed to a post-financial crisis low of 2.2%, signaling that the S&P 500’s valuation is stretched to its breaking point by rising bond yields, according to a JPMorgan Chase & Co. report from May 20.
"The upper limit of what the stock market can withstand in terms of interest rates is now very close," strategists at the bank said in the report, suggesting that further yield increases could threaten the market's stability.
The current 2.2% equity risk premium—the extra return investors expect for holding stocks over risk-free bonds—sits 90 basis points below its long-term average of 3.1%. It has fallen sharply from a peak near 7% in 2020 and is now below the low seen just before the 2007 market downturn.
This compression suggests that further increases in bond yields could trigger a significant rotation out of equities, as investors are no longer being adequately compensated for the additional risk of holding stocks compared to safer assets like 10-year US Treasuries.
Beyond the shrinking risk premium, JPMorgan's model indicates that stocks are expensive in absolute terms. The S&P 500's current implied discount rate is 4.4%, well below the 5% average seen since the mid-1990s. This 60-basis-point gap, when multiplied by a roughly 30-year duration, implies that stocks are overvalued by approximately 18%.
This situation is a reversal from the post-2008 environment. For over a decade, falling interest rates supported higher stock valuations. But since 2022, a rapid rise in bond yields, combined with an AI-driven surge in stock prices, has squeezed the equity risk premium from both sides.
The report also highlighted conflicting forces within the bond market itself. While actively managed bond funds and balanced mutual funds have been increasing their bond exposure, risk parity funds and trend-following CTA funds have been major sellers. JPMorgan noted that CTAs are building short positions in US Treasuries but are far from extreme levels, meaning they have ample capacity to continue selling if the trend persists.
This article is for informational purposes only and does not constitute investment advice.
