By any such measure, the ERP is very high. You are being paid a nice yield to hold equities and almost nothing to hold bonds. This suggests that you should short bonds and buy stocks if you believe in “convergence” (reversion to mean). So why isn’t everybody and his brother shorting the bonds and loading up on equities?
I can think of three possible explanations.
A second possible explanation is that the market expects deflation, which would be bad for stocks and good for bonds. As long as Ben Bernanke is alive, I don’t see this happening.
A third explanation is that the market is discounting a major exogenous shock, which would clobber equities and force a stampede into high quality bonds (and gold).
I can see three possible exogenous shocks on the horizon (in declining order of probability):
- One of the PIIGS defaults and there is chaos in the debt markets leading to contagion all over the place (other indebted countries, European banks).
- Israel and/or the US attacks Iran; Iran attacks the Gulf countries and closes the straits. Oil goes to $250 or higher.
- The North Korean regime decides to exit history with guns and rockets blazing.
As you know, I think that exogenous shock #1 is almost inevitable, and I am very worried about it. The other two could happen but are not inevitable.