All assets compete with each other. Their returns should be proportional to their risk. Equities must have higher projected returns than (most) bonds, which must have higher projected returns relative to cash. This can be measured through what’s called a “risk premium.” Namely, how much additional compensation do investors require to hold equities over mid-grade corporate bonds, mid-duration Treasuries, and cash? This can be obtained by backing out their forward expected returns and comparing the two. Where do you get the yield of equities? You can build out a discounted cash flow model – business values are cash extracted from them discounted back to the present. Or you can do a short-hand method, taking the forward earnings multiple and taking the reciprocal. For example, if SPX earnings are expected to be 170 over the next year and the index is current trading at 2,582, that would imply a forward-twelve-months earnings multiple of 15.2x (2582 divided by 170). The inverse of that is 6.6%. We know that’s a fairly reasonable estimation given that over the long-run, US growth will be about 2% or a little less; inflation will be about 2% or a little less, and there will be some contributions from dividends. Financial assets don’t trade off valuations, but they are nonetheless important to gauge risk. Buying more expensive assets is riskier compared to buying less expensive assets, holding all else equal. Currently, equities look comparatively cheap relative to the 10-year, trading at a 365-bp premium compared to a typical premium of about 300bps. However, equities do not look cheap relative to cash – only an extra 390bps for a lot of extra risk and price movement relative to 539bps historically. They also look expensive relative to BBB credit, with a spread of just 166bps relative to 200bps historically. The cheapness relative to the 10-year and expensiveness relative to cash can be explained by the flat yield curve. Investors are compensated little for owning 10-year Treasuries relative to 3-month Treasuries (cash). This reflects the widespread opinion that short-term interest rates can’t go up much further. Longer-duration bonds benefit more from lower interest rates that shorter-duration bonds. As a rule of thumb, each year of duration is equivalent to a one percentage point appreciation in the bond’s price for each 1% lowering in interest rates. That means that a 10-year bond would typically be around 40x more sensitive to changes in rates than a three-month bond holding convexity constant. Takeaway One might use data points like these to note that equities don’t provide very good reward relative to their risk compared to an alternative asset (e.g., cash). Accordingly, they could decide that they could get equivalent return at a lower risk, or higher return at comparable risk, by leveraging USD cash with a cheaper source of funding (foreign FX) and hedging out the unwanted FX exposure.