Negative Equity Risk Premium: what does it all mean?
I recently read an interesting post on Substack about the state of the market. However, there was one paragraph whose significance might have been missed, even by those who subscribe to the author’s musings.
Here’s the paragraph in question, followed by what I hope will prove a useful explanation.
The paragraph was titled “No Equity Risk Premium.”
“Meanwhile the macro-middle scenario that has prevailed in 2025 has helped stocks push higher, and with still elevated bond yields that has squeezed the forward-looking “prospective equity risk premium” deeper into the negatives. That may not matter this week, this month, or even this quarter, but it does tell us the forward looking risk vs return set points to an entirely different regime than what we’ve become accustomed to.”
The Equity Risk Premium (ERP):
The equity risk premium is the additional return investors expect to earn from investing in equities compared to ‘safer’ investments, such as government bonds.
It’s calculated as the difference between the expected return on stocks and the yield on risk-free assets (typically government bonds, like U.S. Treasuries).
Formula: ERP = Expected Stock Return – Risk-Free Rate (Bond Yield).
For clarity, the Expected Stock Return is an estimate that can be calculated using a number of methods, including the Earnings Yield approach, the Dividend Discount Model, the Capital Asset Pricing Model (a bit of circularity in this one), or even just analyst forecasts or historical average returns.
And yes, it’s all a case of garbage in, garbage out.
Nevertheless, a positive ERP indicates stocks are expected to outperform bonds, rewarding investors for taking on higher risk. A negative ERP however suggests bonds might offer better returns than stocks, which is unusual and could imply stocks are overvalued and less appealing.
The macro-middle:
A “macro-middle scenario” in 2025, probably describes the year’s hitherto relatively stable economic environment – not too hot (inflationary) or too cold (recessionary). This stability has supported higher stock prices.
However, bond yields remain elevated, meaning bonds are offering relatively high returns compared to (at least) recent history.
Prospective Equity Risk Premium:
The “forward-looking prospective Equity Risk Premium” is an estimate of future ERP based on current market conditions, expected stock returns, and bond yields.
The Substack author is positing the ERP premium has turned deeply negative, meaning the expected returns from equities are lower than the yields on bonds. This represents a significant shift from the ‘normal’ scenario, where stocks offer higher returns to compensate for their associated risk.
Negative Equity Risk Premium:
A negative ERP suggests that investors are not being adequately compensated for the risk of holding stocks compared to bonds.
This tends to happen when equity market valuations are high, reducing expected future returns (the higher the price you pay, the lower your returns). It can also occur when bond yields are high, making bonds more attractive relative to stocks.
While the shift might not immediately impact equity markets “this week, this month, or even this quarter”, the proposition is that it signals a longer-term shift in the risk-reward equation being offered to investors.
Regime change:
The now negative ERP points to a “different regime” than what investors typically experience and enjoy. Historically, stocks generally offer a positive ERP (e.g., three to six per cent above bond yields) to justify their volatility, which is a proxy for risk. A negative ERP indicates a market where bonds may outperform stocks, which is unusual and could influence investor behaviour and asset allocation at any time.
Based on forward-looking expected returns, stocks therefore offer little or no additional return over bonds in the coming years.
As an aside, this might also be surmised from a comparison of the S&P 500’s current Earnings Yield of 4.4 per cent (which is just the inverse of the S&P 500’s price-to-earnings (P/E) ratio of 22.7 times forward earnings), and the U.S. 10-year Treasury Yield of 4.10 per cent at the time of writing.
This reinforces the idea that stocks are not providing a sufficient risk premium investors typically expect and deserve, making them now generally less attractive compared to bonds.
What does it mean?
Stocks may be overvalued: If stock prices are high but expected returns are low, investors may be paying too much for future growth that might not materialise. Alternatively, they may be paying too much, considering the typical risk of volatility that can befall markets due to exogenous events.
Bonds are more competitive: Elevated U.S. bond yields render bonds (and we can include Private Credit here too) a potentially safer and more rewarding investment, reducing the appeal of stocks at these levels.
Shift in investor behaviour: While it’s rarely an immediate trigger, a negative ERP could lead investors to favour bonds over shares, potentially slowing stock market appreciation or sparking corrections.
Long-term risks: While the negative ERP may not cause an immediate market disruption, it suggests stocks may underperform bonds over the long term, challenging the conventional wisdom that stocks consistently outperform bonds over time.
As an aside, we might reach the same conclusion by noting the cyclically adjusted price-to-earnings (CAPE Shiller P/E) Ratio’s current level has historically led to subsequent decade compound annual growth rate (CAGRs) in the low single digits.
Why it matters:
Some investors, particularly institutional investors, rely on the ERP to inform their portfolio allocation decisions. A negative ERP could lead to them reevaluating whether stocks are worth the risk, especially in a stable economy where bonds offer solid returns.
Consequently, current settings could signal a structural shift in markets, where bonds receive greater flows or the benefit of portfolio rebalances, or they could indicate stocks are due for a correction to restore a positive ERP.
Example
Let’s say today:
- The expected stock market return (based on earnings yield) is 4.4 per cent annually.
- The U.S. 10-year Treasury bond yield is 4.1 per cent.
- ERP = 4.4 per cent – 4.1 per cent = +0.3 per cent.
In this case, while it isn’t negative, investors would expect to earn a miserly return from stocks compared to bonds, with a lot more risk. If the ERP were negative, it would suggest stocks are objectively less attractive unless their prices fall (increasing expected returns) or bond yields drop. As it stands, our calculation suggests the ERP is positive, but it is nevertheless insufficiently so.
So, the question might be: Is it better to be a few months early, than a few minutes late?
What are the practical takeaways?
- For equity investors: rebalance, rebalance, rebalance. The allocation decision between equities and another asset class is not a mutually exclusive one. You don’t have to be ‘All In’ or ‘All Out’.
Experienced investors follow a plan that includes annual rebalancing. Using a time-based or threshold rebalance, equity investors might for example take profits from one asset class (in this case equities) and rebalance towards more defensive assets with low or no correlation to public equity markets. Alternatively, they may simply rebalance to the original asset class weightings that reflect their risk profile and preferences.
Historically, it has been prudent to be cautious about over-allocating to stocks in a negative ERP environment. Bonds or other income producing assets, such as Private Credit, could potentially offer better risk-adjusted returns.
- For markets: a persistently negative ERP could lead to lower stock market returns or increased volatility if investor sentiment shifts away from equities.
For more information about rebalancing into a Private Credit fund without exposure to property development and with an eight-year track record of attractive returns and no negative months, visit our Private Credit webpage here or call David Buckland or Rhodri Taylor on (02) 8046 5000.
Disclaimer:
You should read the relevant Product Disclosure Statement (PDS) or Information Memorandum (IM) before deciding to acquire any investment products.
Past performance is not a reliable indicator of future performance. Returns are not guaranteed and so the value of an investment may rise or fall.
This information is provided by Montgomery Investment Management Pty Ltd (ACN 139 161 701 | AFSL 354564) (Montgomery) as authorised distributor of the Aura Core Income Fund (ARSN 658 462 652) (Fund). As authorised distributor, Montgomery is entitled to earn distribution fees paid by the investment manager and may be issued equity in the investment manager or entities associated with the investment manager.
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Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
He is also author of best-selling investment guide-book for the stock market, Value.able – how to value the best stocks and buy them for less than they are worth.
Roger appears regularly on television and radio, and in the press, including ABC radio and TV, The Australian and Ausbiz. View upcoming media appearances.
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