The real riddle lies in the yields of bonds and stocks.
The fundamental laws that kept the global financial system in balance for 40 years have just broken. In a historic deviation from all economic logic, Wall Street has been swept into a blind, almost paranoid rally, where risk-heavy stocks now cost more than the "safe havens" of government bonds. As traditional mathematical models collapse and investors seem to defiantly ignore the mammoth US deficits and the geo-economic upheavals of the Trump era, market participants are worrying about the most dangerous bubble of the last few decades.
The... riddle of bond and stock yields
"If something cannot go on forever, it will stop." This was stated in 1986 by Herb Stein, former chairman of the US Council of Economic Advisers, referring to the American debt. Investors may need to heed Stein's quote again, this time regarding asset valuations. Because—according to an article in the Financial Times—a strange (and potentially unsustainable) paradox is currently haunting the markets. No, it is not (only) the lukewarm reaction of oil prices to the Iran war so far, nor the impressive size of upcoming initial public offerings (IPOs) from SpaceX and Anthropic. The real riddle is the yields of bonds and stocks. For decades, students of economics were taught that stock yields are supposed to be higher than those of bonds, to compensate investors for the risks associated with corporate earnings and market cycles.
As Smith Affiliated, a New York-based investment advisory firm, points out in its latest investor letter, between 1990 and 2026, the yield on American stocks was indeed on average 2.3 percentage points above the yield on 10-year government bonds. (Smith arrived at this figure by dividing S&P 500 corporate earnings by the market price, which is undoubtedly the simplest current measurement). However, "today, this relationship looks very different," Smith notes: the earnings yield of the S&P 500 was around 3.6% in early June, about 0.85% below the yield of the 10-year US Treasury bond. Financial logic has been completely overturned. Other analysts calculate this stock yield differently. JP Morgan, for example, uses a complex Dividend Discount Model that predicts future (not current) earnings and discounted cash flows. But the message is similar: between 1996 and this year, the JPMorgan equity risk premium mostly hovered around 5%. Since bond yields began to fall three decades ago, approaching zero, a large positive gap was created between stocks and bonds.
The paradox with stocks
Now, however, 10-year yields exceed 4.5%, so the gap has narrowed in JP Morgan's models, which means that "stocks look rather expensive... on an absolute basis compared to the standards of the last 30 years," according to the bank. And "stocks currently look even more expensive relative to bonds." This is strange. After all, when market interest rates rise sharply—as is happening this year—this usually hits corporate profits and makes buying bonds more attractive for investors. Yet, the S&P 500 has (mostly) ignored this. Why? One possible explanation is that bonds are mispriced, either because inflation is about to fall sharply, because governments are preparing to drastically cut their debt, and/or because a recession is imminent. However, US inflation has just touched 4.2%, first-quarter growth was 2%, and the US deficit hit a record $1.2 trillion for the first eight months of this fiscal year, while the Treasury Department forecasts a $2 trillion deficit for this year.
Therefore, a second possibility is that, in reality, it is stocks that have been mispriced. This seems more likely. After all, the recent frantic rally in technology—and the excitement surrounding Artificial Intelligence (AI)—largely explains the rise in stock indices, even though tangible profits from AI have so far been meager.
Risk of investment "indigestion"
The worst part is that there could soon be investment "indigestion" with all the upcoming IPOs, given that we also appear to be entering a new investment cycle and the Treasury Department must sell $10 trillion in bonds over the next year. As Smith says, we are facing "the return of competition for capital." This is very different from the previous decade of excess liquidity, which boosted stock prices. However, if you believe that stocks are mispriced, you must face two other facts: corporate earnings remain strong, even outside the technology sector; and most technocrats (and investors, it seems) are convinced that the future profits of technology will skyrocket.
Waiting for a miracle
Thus, discussions at a Founders Forum meeting in the UK this week concerned a future miracle of earnings, productivity, and growth to be triggered by AI, which could reduce inflation. For the tech world, then, it is bonds—not stocks—that appear mispriced. US Treasury Secretary Scott Bessent seems to agree. If this proves correct, everyone can celebrate. However, the FT columnist remains cautious and fears that there is a third explanation for this riddle: investors are so dizzy and confused that valuation models are collapsing.
Will this market paradox last? Probably—at least for a while. After all, Stein made his witticism four whole decades ago, but the debt continued to balloon. And in the world of stocks, the dotcom bubble lasted longer than anyone expected (also producing low stock yields). But, if nothing else, investors should pay attention to this riddle and then ask themselves what they trust: a promise from the US government that it will bring debt and inflation under control? Or a commitment from technocrats that they will deliver crazy future growth? Or neither? The answer is of immense importance, especially if capital scarcity truly returns.
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