Ridin’ High

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What's going on?

This here stock market’s had some ups and downs this year, but according to Goldman Sachs, there are still more rootin’ tootin’ returns to be had. Yeehaw!

What does this mean?

Goldman’s math is based on the “equity risk premium”, or ERP: that’s the extra profit investors expect to earn from risky stocks compared to theoretically risk-free government bonds. So while stocks are currently at record highs, Goldman reckons the ERP is too – suggesting they’re still a better bet than bonds.

Here’s why: there’s an inverse relationship between bond yields and the ERP, so as bond yields have fallen to record lows, the ERP’s climbed close to all-time highs. What’s more, those low bond yields would ordinarily suggest investors are worried about weak future economic growth, which is usually a sign to sell their stocks. But since central banks – which have been buying up bonds to prop up their economies, driving yields down – are largely responsible, investors have carried on buying stocks anyway.

Why should I care?

For markets: Relationship goals.

Goldman’s worked out that, in Europe, a one percentage point decrease in bond yields theoretically adds 30% to the value of European stocks, thanks to the corresponding increase in the ERP (tweet this). That relationship’s even stronger in the US, where 90% of the ERP’s rise can be explained by falling government bond yields. And given that the Federal Reserve just hinted it’ll keep the US’s interest rates – and, by extension, bond yields – low for longer, US stocks might now be even more promising than Goldman thinks.

For you personally: That’s so next year.

Based on Goldman’s math, stocks should offer positive returns relative to bonds for the next 12 months. But in a year’s time, Goldman isn’t expecting there to be anything to choose between US stocks and bonds – though in Europe, stocks might still be outperforming bonds.

Originally posted as part of the Finimize daily email.

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