Wednesday, August 30, 2023
- The increase in interest rates in recent months has left equity valuations more challenged.
- Based on the Equity Risk Premium (ERP), the S&P 500 Index offers very little additional compensation for equity investors relative to fixed income, which offers some of the most attractive yields in decades.
- The ERP is one of the primary reasons that LPL Research has a slight preference for fixed income over equities in its current recommended tactical asset allocation, but consider that valuations have not historically been good short-to-intermediate term timing tools.
- LPL Research suggests sourcing a slight fixed income overweight from cash to maintain a neutral equities allocation relative to appropriate benchmarks.
What is the ERP?
Let’s start with the basics. We can measure the relationship between stock and bond valuations by comparing earnings yields to bond yields, giving us the so-called equity risk premium (ERP). The earnings yield is simply the inverse of the price-to-earnings ratio, which is currently at 22 based on trailing four quarters S&P 500 earnings per share (EPS).
The ERP compares the earnings yield on the S&P 500 (the inverse of the price-to-earnings ratio, or P/E) to the 10-year US Treasury yield. The inverse of 22 gives us an earnings yield for the S&P 500 of about 4.5%
We can then compare that 4.5% number to the 10-year Treasury yield (not risk free but referred to as a “risk-free rate” in the textbooks). The 10-year yield is trading at 4.11% currently, down from a recent closing high of 4.34% on August 21. Take 4.5% minus 4.11% and you get roughly 0.4%, the current ERP for the S&P 500 as shown in the chart below.
LPL Research believes the ERP gives investors a more complete valuation picture. Going back to those finance textbooks again, the theoretical value of a stock is the present value of future cash flows. So, a higher interest rate raises the discount rate, which then lowers the value of those future cash flows discounted back to today’s dollars. From that perspective, rates should be part of any valuation discussion for the stock market.
Also consider that investors have a choice between stocks and bonds. Of course, there are other choices like alternative investments, real estate, commodities, etc., but for this exercise we focus on the two primary investment options, stocks and bonds. As interest rates rise, bonds become relatively more attractive because of higher yields. This is another important reason why interest rates matter to stock investors. You might say fixed income investments are a competitive threat for stock investors.
Does the Low ERP Really Matter?
The S&P 500 ERP of 0.4% is low but not much below the long-term average of 0.7%. However, 0.4% is the lowest the ERP has been since before the 2008-2009 financial crisis. Essentially, the S&P 500 Index offers very little additional compensation for investors to take on equity risk relative to fixed income, which offers some of the most attractive yields in decades.
The logical next question is how much do valuations influence future stock market performance? The data is quite mixed on that. In fact, based on monthly data back to 1990, the S&P 500 has gained an average 8.7% in the year after registering an ERP between 0 and 1%. Below-average performance has typically come at the extremes, particularly at minus 2% and below which is where we were in the first quarter of 2000 at the peak of the dotcom bubble.
Bottom line, the low ERP is perhaps a reason to temper expectations a bit for stock market gains in the coming year, but that assumes rates stay this high or go higher. If rates fall, as LPL Research anticipates as the economy potentially slows and inflation comes down further, then stock valuations may garner support. So the low ERP is not a valid reason to be bearish on equities, in our view, especially given that expectations for company earnings have improved quite a bit recently as recession fears have abated.
Asset Allocation Considerations
The low ERP is one of the key reasons that LPL Research has a slight preference for fixed income over equities in its current recommended tactical asset allocation. Valuations have not historically been great timing tools over the short-to-intermediate term, but when they are high, they do raise the bar for the economy and corporate America to deliver enough good news to push stocks higher. We see this as a reason to temper enthusiasm for equities, not to be bearish. We remain neutral equities and suggest sourcing a slight fixed income overweight from cash, relative to appropriate benchmarks.
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