Invest1 publisher2 min readPublished
Rising real yields squeeze the stock premium over TIPS below one point
S&P 500 stocks earn 3.8% against a 2.86% real yield on 10-year TIPS, a premium under one point versus a long-run 3.5% average, Fortune calculates. Only brief spells in the financial crisis and the COVID crash, when earnings collapsed, have produced a thinner cushion in more than two decades.
The Investor · Invest desk
What happened
- The 10-year TIPS yield rose 110 basis points between early March and September 26, its highest level since 1999-2001 apart from a few weeks in the financial crisis.
- The S&P 500 trades at 26.2 times its trailing 12-month GAAP earnings.
- From August 2010 to December 2022 the TIPS yield averaged 0.6% while the index traded near 20 times earnings, a premium of 4.4%.
- Fortune calculates the premium has shrunk 77% from that level as stocks got pricier and Treasuries got much cheaper.
Compiled by The InvestorSomething wrong?How this is made
Why it matters
- decision Moving money from the index into 10-year TIPS now gives up only about 0.94 points of expected annual return, so cutting equity risk costs far less than the long-run 3.5-point average implies.
- exposure Bonds did about 65% of the squeeze since the 2010-2022 stretch, so what stockholders are paid for risk now moves mostly with real yields set in the Treasury market.
- contradiction The 'almost 4x' gap to history sets a TIPS-based reading against an academic average dating to 1871, though TIPS have traded only since 1997, so the long-run benchmark was estimated a different way.
Kenneth French, the Dartmouth financial economist, told Fortune the premium is "the holy grail of stock market investing" [2]. The version Fortune computes is simple. It sets the past 12 months of GAAP profits per $100 of index against the real yield on a 10-year TIPS [1].
There are three routes back to the long-run average of about 3.5% [8]. Each can be sized, or rather each can be sized once the other two variables are held still. Keep the real yield at 2.86% and the index needs an earnings yield of 6.36%, a multiple of about 15.7 against today's 26.2 [3]. On flat profits that is a price fall of about 40% [3]. Keep the price instead and profits have to rise about 67% [4]. Keep both and the TIPS yield has to drop to about 0.3% [5] (half its 2010-2022 average, from a stretch Fortune describes as one of exceptionally low real rates) [10].
I think the evidence supports a smaller equity weight against TIPS for anyone who owns the index for its premium over safe bonds, and a higher bar for new money going into it. The alternatives pay without equity risk. TIPS offer 2.86% a year above inflation [3], and the ordinary 10-year pays 5.2% nominal [6].
The view is wrong if earnings grow fast enough to close much of that 67% gap [4]. Anyone paying 26.2 times trailing profits [5] is already making that bet. Fortune's measure would register the growth only after it was booked, because it runs on the past 12 months of earnings [1].
What to watch
- The 10-year TIPS yield near 3.8%: a further 94 basis point rise, smaller than the move since March, would leave no premium at today's earnings yield, as happened in parts of 1999-2001.
- A reversal of the spring rise in real yields: back at the early-March level of about 1.76%, today's earnings yield would give a premium of about two points.