“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.” – Warren Buffett (Trades, Portfolio)
Is the stock market cheap or expensive? It depends on who you ask.
Today, just like the 2005 to 2007 financial boom and dot-com bubble just before, analysts and investors are coming up with all kinds of different valuation metrics to justify paying a high price for equities and other investable assets.
The latest justification trend is the argument that as bond yields are currently plunging to record lows, then stocks should be higher to reflect that.
This argument has a well-founded financial principle behind it in the equity risk premium. Investors should be compensated for the extra risk they are taking on by investing in equities. Therefore equities should offer a higher long-term return on bonds. Calculating the equity risk premium requires two key data inputs, the estimated expected return on stocks and the estimated expected return on safe bonds. The difference between the potential return on equities and current bond yields is known as the equity risk premium.
Can you trust the equity risk premium?
A quick glance at the definition above will tell you that the equity risk premium actually has little to do with underlying stock fundamentals, and this is a problem.
Analysts at Deutsche Bank estimated that 92% of the current Standard & Poor's 500 rally (2012 to 2016) is the result of equity risk premium compression, the highest it’s been in the past four market cycles (1983 to 1990, 1996 to 2000, 2003 to 2007 and 2012 to 2016). Further analysis shows that 17% of the recent rally has been down to multiple expansion while -9% is due to earnings growth.
If you compare this to previous market cycles, the 2012 to 2016 cycle has been the weakest bull market in history. Earnings growth constituted 92% of the 1983 to 1990 cycle, 51% of the 1996 to 2000 cycle and 127% of the 2003 to 2007 cycle (in this cycle multiple expansion and equity risk premium compression detracted 27% from the rally).
Deutsche’s analysts don’t expect this trend to end any time soon. Indeed, they calculate that over the past three decades the equity risk premium is around 2% and today the premium is some 2% higher than this historical average. To make up the difference, they calculate the S&P 500 could rally by another 200 points as the risk premium returns to its historical norm.
Whether this rally is sustainable with no earnings growth to back it up is a different matter.
Stocks are expensive
Taking the other side of Deutsche’s optimistic analysis is BCA Research. BCA’s analysts have calculated the equity risk premium on U.S. stocks all the way back to 1871. Their findings show that between 1871 and 2016, the equity risk premium on U.S. stocks averaged 5.5%. Today, analysts estimate the equity risk premium stands at just 4.7%, 800 basis points lower than the 145-year average.
By combining both Deutsche’s and BCA’s findings, an interesting picture emerges. Based on long-term trends, the market is overvalued according to the equity risk premium. What’s more, considering that over 90% of the recent rally has been a direct result of equity risk premium compression, investors need to ask themselves if the current risk premium of 4.7% compensates them adequately for the risk taken on.
The answer to this question is more than likely to be no.
Still, these figures are not set in stone. A further decline in bond rates or a sudden move by the Federal Reserve to hike interest rates could dramatically change the entire calculation.
On the other hand, if earnings growth suddenly picked up, the rally would get a new tailwind behind it that could drive the S&P 500 to new heights as multiple expansion and earnings growth complemented equity risk premium compression.
Focus on the fundamentals
For the average investor, however, talk of the equity risk premium is somewhat irrelevant. By using a bottom-up analysis, it is still relatively easy to discover companies that have a long runway for growth with cash-rich balance sheets and low valuations.
As market valuations continue to expand, it is becoming increasingly important to adopt and rigorously follow a value investing methodology, only deploying your cash into the best, cheapest opportunities, not following the herd and protecting the downside. Low-interest rates have helped disguise poorly run companies with weak balance sheets and investors should have Buffett’s Rule No. 1 at the forefront of their minds in this uncertain time.
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