A key indicator reveals that the risk premium investors demand for holding stocks over bonds has climbed to its highest level in more than two years. As conflict in Iran drives oil prices sharply higher, concerns are mounting that the U.S. economy could be heading toward a stagflationary environment reminiscent of the 1970s.
This metric, a variant of the equity risk premium, measures the extra compensation investors expect for holding stocks instead of risk-free U.S. Treasury securities. Calculated by Aswath Damodaran, a New York University finance professor renowned for valuation research, the indicator approached 4.8% in early April, marking its highest point since the end of 2023.
As Middle East tensions rapidly escalate, investor risk appetite has weakened. The S&P 500 index declined as much as 9% from its peak, while oil prices surged and worries about rebounding inflation intensified, drawing greater attention to this risk premium. For some observers, the current backdrop is beginning to evoke uneasy comparisons with the 1970s, a period characterized by energy crises, stagnant economic growth, soaring consumer prices, and poor stock market returns.
Dennis DeBusschere, President and Chief Market Strategist at 22V Research LLC, noted that the current equity risk premium is "consistent with a stagflationary environment like the 1970s." His firm utilizes Damodaran’s indicator. DeBusschere warned that if the premium rises further toward median levels seen during the 2008 financial crisis and the 1970s—currently less than one percentage point away—the S&P 500 could experience an additional decline of 5% to 10%.
Damodaran’s risk premium metric incorporates cash flow projections and expected returns on S&P 500 stocks, then subtracts the 10-year Treasury yield. The indicator stood at 3.99% in early December. Damodaran also pointed out that the traditional equity risk premium—calculated as the S&P 500 earnings yield minus the 10-year Treasury yield—has continued to rise since the outbreak of war.
Of course, investors have previously been unsettled by similarities to the 1970s, only to see stagflation fears eventually recede. Following the Russia-Ukraine conflict in 2022, spiking oil prices drove inflation to multi-decade highs and contributed to a nearly 20% drop in the S&P 500 that year. However, inflation subsequently eased, the U.S. economy demonstrated resilience, and equities went on to reach new highs. Recent U.S. data also point to economic strength, including a better-than-expected jobs report for March.
Bullish investors further highlight that enthusiasm around artificial intelligence continues to support the stock market, and corporate outlooks remain optimistic. According to industry research compilations, full-year earnings for S&P 500 companies are projected to grow by 17%, with growth accelerating from 12.5% in the first quarter to 19.3% in the second.
Clues on the direction of inflation may emerge from the U.S. March consumer price data due on Friday, while corporate earnings season is set to begin later this month. Nevertheless, Michael O’Rourke, Chief Market Strategist at JonesTrading Institutional Services LLC, wrote in a Sunday report that investor risk appetite is unlikely to improve until the trajectory of the conflict becomes clearer.
He stated, "In an environment lacking visibility, investors tend to adopt a more defensive stance." This implies they will demand a "higher risk premium" before committing capital.
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