Equity-risk premium turns negative, but that’s not a sure sign of stock weakness

Conventional wisdom has it that the corporate earnings yield should generally be higher than the 10-year Treasury yield.
That’s not the case now, and it could have negative implications for stocks. But it’s not clear that the conventional wisdom is correct in the first place.
The earnings yield is the reciprocal of the price-earnings ratio – i.e. earnings divided by price. The S&P 500 earnings yield minus the 10-year Treasury yield amounts to what’s sometimes known as the “equity-risk premium.”
That’s the reward investors demand to invest in risky stocks rather than safe Treasuries. A high earnings yield means stock buyers aren’t paying much for each dollar of earnings. So a large premium is said to mean that stocks are attractive compared to bonds.
The equity-risk premium has just turned negative for the first time since 2010, a year after the great financial crisis ended. As of Jan. 24, the earnings yield stood at 4.5%, compared to 4.63% for the 10-year Treasury yield. That left the equity-risk premium at negative 0.13%
The low earnings yield results from the fact that stock prices (the denominator in the earnings yield ratio) have soared in the past five years.

Implications of negative equity-risk premium
The standard thinking is that a negative equity-risk premium bodes ill for stocks, because it indicates they’re overvalued compared to bonds. However, right now, investors are pouring money into stocks, with the S&P 500 hitting a record high just last week.
It could well be that stocks are overvalued. The S&P 500 price-earnings ratio stood at 22.2 Jan. 24, well above the five-year average of 19.7 and the 10-year average of 18.2.
But a negative equity-risk premium doesn’t prove much. The premium was negative from 1981-2009, yet the S&P 500 rose in 22 of those 29 years.
All this illustrates that it’s extremely difficult, if not impossible, to come up with ironclad rules that determine where stocks are headed. One based on equity-risk premium levels clearly doesn’t do the trick.