By David Rosenberg and Marius Jongstra
For the better part of the last cycle, back in 2009, investors turned to equity risk premium (ERP) in the US as the main refutation against claims of overvaluation, arguing that low levels of bond yields make the stock market more attractive. in comparison. This assertion, that “there is no alternative” (TINA), has completely evaporated as interest rates rise.
At current levels, investors can get a return of four percent on a two-year Treasury, or more than 3.5 percent on a ten-year term. Compared to bonds, the stock market is back at its lowest attractiveness since late 2007, with additional compensation for risk at just 270 basis points.
Although the S&P 500 is in the midst of a correction of 20 percent or so, ERP has shrunk since the market peaked on Jan. 3. Using history as a guide, this is very unusual, as it usually needs to expand by +425 basis points, on average, before bear markets are over. Until such a development occurs, it is best for investors to fend off requests to reach the bottom of the market, as the risk/reward profile, by this calculation, remains unfavorable with more negative trend ahead.
Interestingly, after the initial expansion following the January 3 market peak, the risk premium began to shrink dramatically as the rise in bond yields dwarfed the improvement in the S&P 500 dividend yield. Note that our definition of ERP is calculated by subtracting the Treasury yield. The 10-year S&P 500 (also known as the Federal Reserve) index future dividend yield.
By plotting the trajectory of this current episode compared to the average and range of previous bear markets, using Bloomberg data going back to 1990, it becomes clear how strange this sell-off period has been compared to history, as well as how much work needs to be done to be caught. In just over 180 trading days since the highs, ERP has compressed by 30 basis points compared to the historical average of the 100 basis point expansion that has typically occurred.
Our work shows that the bottom is not set until ERP expands by 425 basis points. Most importantly, while the range varies from +137 basis points to +623 basis points, no bear market would have bottomed without ERP expanding at all. Even at its lowest level in mid-June, the increase in equity risk premium was as low as 30 basis points, to just over 300 basis points. That’s a far cry from the historical average change, and on a level basis, like the 70th percentile reading in the post-QE period. Such a modest improvement, to a level still historically high, does not indicate a market bottom in our view.
It is undeniable that this corrective phase has followed a different pattern than similar periods in the past, not thanks to the current inflationary pressures and upward effect on bond yields. And while there are many moving parts on how to normalize ERP, the stock market is unlikely to stay the same, especially with the late effects of the US Federal Reserve tightening not being fully reflected in corporate earnings expectations.
For illustrative purposes, if we assume an even split in terms of contribution from equities and treasuries toward the ERP expansion, achieving a +425 basis point change translates into a decline in the 10-year US Treasury yield of about 1.5 percent alongside a roughly 20 percent drop in cent in the S&P 500 from current levels. If interest rates prove more flexible, stocks will have to fall even more.
As always, while our analysis focuses on the headline level, it doesn’t mean that there are no opportunities beneath the surface for investors to explore. In the accompanying table, we calculated ERP across various S&P 500 segments as defined by forward earnings yielding lower returns than comparable investment grade bonds (aka using the modified Federal Reserve model approach). Two main results emerge.
First, on an absolute basis, only five sectors offer any kind of yield increase that is feasible relative to comparable bonds: energy (premium 7.9 percentage points), finance (2.7), materials (2.6), healthcare (1.4) and telecoms services (one). The remaining group (industry, basic consumer goods, utilities, technology, and consumer appreciation) has dividend yields in line with or below their corporate bond equivalents, meaning investors are better off buying these companies’ fixed income products because there is little or no additional compensation for risk Property rights.
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Second, from a forward-looking perspective, what’s jumping around is how compact the ERP system has historically been in so many sectors. Every sector except Energy and Material is in a maximum percentage reading, which means that the potential for continued pressure is much lower.
In the end, ERP is just another evaluation tool, which doesn’t offer impressive timing capabilities, but does provide a window into what future returns will look like. On this basis, in terms of exposure to equity, energy and materials look the most attractive.
However, it is clear that the stock market in general has not been sufficiently re-priced to account for higher interest rates. Against this background, the path of least resistance for the S&P 500 is likely to remain to the downside. What has happened with ERP so far is simply not enough to call the bottom yet.
David Rosenberg is the founder of the independent research firm Rosenberg Research & Associates Inc.. Marius Jungstra is a senior economist and strategist there. You can sign up for a one-month free trial on the Rosenberg website.
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