Lately, there’s been an interesting trend developing in the markets: Treasury yields have been falling, while stock prices have moved sideways or up.In other words, the prices of risky assets have held up, while the prices of risk-free assets haven’t seen an offsetting sell-off.
There may actually be a very simple explanation for this: the equity risk premium is shrinking. Oppenheimer’s Brian Belski discusses this in his latest US Strategy Weekly note.
One of the most striking market characteristics is that the “reward” for taking equity risk remains near an all-time high. However, we believe that current equity risk premium (ERP) levels are unsustainably high and poised to fall to more “normal” levels this year. Furthermore, we believe that this will occur mainly through an expansion of market multiples (as opposed to an increase in interest rates) since earnings quality has begun to improve in recent months and market fear is beginning to quickly subside.
Simply put, the equity risk premium is the additional return investors require of equities relative to risk-free assets.
So, it seems we are witnessing the relative risk appetite returning.
But does this mean we’re entering a new risk bubble?
Belski’s note includes a historical chart of the ERP. Clearly, there’s a lot of room for the ERP to shrink, which could continue to fuel the bizarre divergance everyone’s witnessing in the stock and Treasuries markets.