US stocks ridiculously expensive? Analyst: Don’t panic, “risk premium” is still profitable.

US stocks ridiculously expensive? Analyst: Don’t panic, “risk premium” is still profitable.

US equity valuations are elevated, and concerns about equity risk premium are rising in the market. However, a Bloomberg column points out that the commonly used calculation methods have methodological flaws. After reasonable adjustments, US stocks are expensive but have not yet reached dangerous levels.

Bloomberg columnist Nir Kaissar notes that the S&P 500 dividend yield is only 1.1%, far below the 4.5% yield of 10-year US Treasuries. This huge gap has made many investors worried that the equity risk premium has vanished. Yet the author believes such comparisons are inherently flawed—dividend yield cannot fully reflect a company's true profitability, and using it to judge stock market risk leads to biased conclusions.

Using a more reasonable blend of profit metrics, the recalculated equity risk premium for the S&P 500 is about 2.3%. Although below the historical average, it remains within controllable bounds and does not constitute a systemic warning. For investors who allocate assets based on the risk premium, the current level still supports moderate overweighting of stocks versus bonds, and equity assets continue to provide positive risk compensation.

When valuations are high, investors instinctively compare stock returns with bond interest. Theoretically, stocks must offer higher returns than bonds as compensation for greater volatility (“risk premium”); and when this premium disappears, the market often interprets it as a warning signal.

The two most popular comparison methods each have significant flaws.

The first is a direct “dividend yield vs. Treasury yield” comparison. Comparing the S&P 500’s mere 1.1% dividend yield with the 4.5% US Treasury yield leads to alarming conclusions. But the problem is that dividend yield captures only the “tip of the iceberg” of corporate profits. Nowadays, companies prefer buybacks over dividends, so the dividend yield no longer represents total shareholder returns, making it an extremely unconvincing anchor for valuation.

The second is replacing dividend yield with “earnings yield.” But this risks comparing apples to oranges—the Treasury yield is purely nominal, while earnings yield incorporates real growth expectations and is easily affected by inflation and price volatility. Simply subtracting these two numbers from different dimensions is not logically rigorous.

Valuation Pressure Eases After Adjusting for Inflation

A more reasonable comparison framework should align earnings yield with the real Treasury yield.

Currently, the 10-year breakeven inflation rate (the spread between regular Treasuries and TIPS) is about 2.2%, so the real Treasury yield is roughly 2.3% (4.5% nominal minus 2.2% inflation expectation), rather than the headline 4.5%. After adjusting the benchmark, the valuation pressure on stocks is significantly reduced.

However, resolving the discrepancy in methodology leaves the definition of earnings as the real challenge. For the same company, using different periods of earnings yields dramatically different conclusions:

  • Expected earnings for the next 12 months corresponds to a yield of about 5.0%, most timely but relies on short-term extrapolation and easily misses inflection points.
  • Actual earnings from the past 12 months corresponds to a yield of about 4.0%, more real but highly volatile with significant noise.
  • Cycle-adjusted earnings (CAPE), using a 10-year inflation-adjusted average, yields only 2.6%, close to the real Treasury yield (~2.3%). It smooths volatility but systematically underestimates current earnings due to the long-term upward trend.

Each of the three metrics has its own applicable scenarios and blind spots. Choosing among them essentially means trading off timeliness, authenticity, and stability.

The “Distortion Moment” of Cycle-Adjusted Metrics

When earnings growth far exceeds the historical average, cycle-adjusted earnings (CAPE) dramatically understates current earnings. Long-term tracking by Yale professor Robert Shiller shows that since 1881, actual earnings for the past 12 months have only surpassed CAPE by about 11% on average; currently, this gap has soared to over 60%.

The root cause is the explosive surge in earnings growth. Since the post-pandemic recovery in 2021, S&P 500 earnings have grown at a compound annual rate of 13%—about double the average since the 1950s, and more than triple the trend growth rate since the 1870s.

High growth is directly reflected in the huge gap between forward expectations and cycle averages. According to Bloomberg data, consensus market forecast for S&P 500 earnings per share over the next 12 months is $365, while CAPE is only $188. The former is almost double the latter. Looking back to 1990 (the earliest year with analyst forecasts), the current gap is the largest on record.

Hybrid Method Estimate: Stocks Are Expensive but Not Dangerous

The two extreme metrics each have biases: CAPE is overly conservative due to tech giants’ high profit growth, while forward estimates may be too optimistic given mean-reverting earnings cycles.

An intermediate approach uses five years of historical earnings and three years of forecasts to build an eight-year average. On this basis, normalized S&P 500 earnings are $333 per share, corresponding to a yield of 4.5%. Subtracting the 2.2% breakeven inflation rate gives an equity risk premium of about 2.3 percentage points.

This level is below the historical average, but the deviation is limited. Conclusion: Valuations are expensive, but not flashing a red light yet—for investors referencing the equity risk premium, stocks still offer positive risk compensation.

Risk Warning and DisclaimerThe market carries risks, and investment requires caution. This article does not constitute personal investment advice, nor does it take into account the specific investment objectives, financial situation, or needs of individual users. Users should consider whether any opinions, viewpoints, or conclusions in this article suit their particular circumstances. Investing based on this article is at your own risk.