Even after an historically rapid drawdown in February/March, the S&P 500 (SPY) is ending 2020 hitting new all-time highs. In a companion article published yesterday, I showed a 66-year history of trailing price-earnings (P/E) ratios when the market hit new peaks. Today’s market multiple of around 28.8x is meaningfully above the average P/E ratio of 18.4x when the market has hit past peaks.
Each data point in that sixty-six year history is different. Each market environment is at a different part in the business cycle, has a different growth trajectory, a different geopolitical backdrop, and is dominated by different industries. Maybe most importantly for readers; however, was that each environment also had a different interest rate environment influenced by differing rates of expected future economic growth and inflation.
In this article, I want to build on the P/E ratios I used for the last piece. By flipping the P/E ratio on its head, we get an earnings yield (earnings/price). By then subtracting the 10-year Treasury yield from this earnings yield, we can get a proxy of an equity risk premium, or an incremental nominal premium that investors have needed to be paid for holding equities over risk-free assets. This article will look at what the equity risk premium has been over time with a focus on comparisons to previous all-time highs.
Since the value of a stock today is its future earnings or shareholder dividends discounted back to the present, then price-to-earnings ratios should be in part a function of changes in interest rates. When we look at a graph of the S&P 500 earnings yield and the 10-yr Treasury yield, we see them moving in close tandem. Below I have graphed the S&P 500 earnings yield and 10-yr Treasury back to the start of 1962, the longest daily dataset I have available for Treasury yields.
In the next graph, I have taken the difference between these two yields. By subtracting earnings yield by 10-yr Treasury yield, we get our proxy for the equity risk premium (blue). Since this risk premium has changed over time, I have also plotted its long-run average in red.
Finally, I have highlighted what this relationship has been at market peaks (the red dots on the next graph). At market peaks, this proxy for the equity risk premium has been slightly positive (+0.13%). Note that the market has made peaks when this equity risk premium measure has been high and when it has been quite low.
The current earnings yield (3.47%) less the 10-yr Treasury yield (0.95%) produces a difference of 2.52%. The equity risk premium has actually only compressed marginally in 2020 with expanding equity multiples nearly offsetting the decline in interest rates. Market bulls point to this healthy differential and suggest that equities still look like very good value to fixed income.
Market bears may suggest that extraordinary monetary accommodation around the world, once again accelerated by the virus-induced slowdown, has made all assets expensive, and that expensive stocks and bonds suggest low forward returns for both. Another point for bears would be that while the current equity risk premium is high versus this long historical time series, the current premium is not high versus its recent past. The equity risk premium was not this narrow at any point in 2019 or from February 2011 – November 2016.
For me, a fairly priced market is when both bulls and bears can make compelling cases. I tend to view the equity risk premium as compensation for uncertainty. The challenging unwind of easy monetary policy, stimulative fiscal policy to offset the virus-induced slowdown, tensions between the two largest economies, and a global health crisis make for a unique market backdrop. The market has likely pulled forward some post-vaccine economic growth into current valuations, but as recent headlines about the slow vaccine rollout and potential for mutations have shown us, the vaccine announcement is the beginning of the end of this crisis and not its terminal point and there will be some degree of uncertainty ahead.
Equities are not absolutely cheap, but they appear at least less extraordinarily expensive when juxtaposed on a relative basis against this current low inflation and low interest rate environment. Even through this equity risk premium lens, however, that current premium is less robust than it has been in the recent past. Over the past ten years, the equity risk premium has averaged 3.37% versus 2.52% today. If a driver of stock gains has been “there is no alternative”, the relative attractiveness of stocks versus bonds (even with their paltry nominal yields) has declined versus its recent past.
I hope this framing exercise is useful for Seeking Alpha readers as a supplement to the previous article on P/E ratios at market highs. Please share your thoughts in the comments section.
In future articles I plan to examine the market valuation amidst new all-time highs in a myriad of additional ways. The next two on my agenda will likely be:
- Excess CAPE Yield, which will use interest rate adjustments with a common longer-term valuation metric;
- Investing at Market Tops, which will examine forward returns from previous market peaks.
Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.
Disclosure: I am/we are long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.