Unlocking the Hidden Truth: Is the Market Shortchanging You for the Risks You Take?
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In the world of investing, the concept of an equity's "risk premium" has long been associated with the expected yield surpassing that of 10-year treasury debt. While this idea holds true in conventional times, our current financial landscape is anything but normal.
Amidst Money Market Fund rates still exceeding 5% and the inversion of US debt yield curves, the traditional approach of using the 10-year treasury rate to calculate equity risk premium might be leading investors astray. This begs the question: are investors truly being compensated adequately for the risks they're shouldering?
In this topsy-turvy world, where low-risk money market funds boast higher yields, perhaps it's time for a paradigm shift. Instead of relying on long-dated bonds, why not invert our perspective and consider the shorter-term yields offered by money market funds? This approach might provide a more accurate representation of what investors are genuinely earning by holding equities.
To illustrate this, let's challenge the common assumption that the expected returns of the S&P 500 stand at around 7%. Many investors would traditionally use the 10-year US bond rates of about 4% as the basis for an “alpha” creation calculation, concluding an equity risk premium of 3%. But is this time-honored approach still valid?
The traditional method overlooks the availability of risk-free investments yielding 5.3% or even 5.5% through money markets and short-term debt. In an era where the yield curve remains inverted for an unprecedented duration, investors adapting to a "new normal" might price the actual equity risk premium as low as 1%. This shift may seem bold, but it aligns with the growing trend of institutional investors flocking to these funds, propelling US money market fund balances to $6 trillion and global balances to $9 trillion. For those who may question the use of a money market fund in place of a “risk free asset,” please consider the fact that money market funds hold primarily made up of these same risk free assets, albeit in much shorter durations.
Given the volatility in US treasury rates over the past year due to the Federal Reserve's efforts to manage inflation, it becomes evident that short-term rates offer a more accurate reflection of what consumers pay for essentials like mortgages and credit cards. Therefore, these rates should play a more significant role in determining the equity risk premium.
In conclusion, the financial landscape is evolving, and investors may need to recalibrate their thinking to ensure they're not being shortchanged for the risks they undertake. It's time to consider a more nuanced approach that reflects the realities of our inverted financial world.