Thread by @TimmerFidelity

Following up on the previous thread, as we seek to answer the question: “Is the market a bubble that is ready to burst?” The next factor to look at is the equity risk premium. (THREAD)

The discount rate (or cost of capital) consists of the risk-free rate (10 year Treasury yield) plus the equity risk premium. The ERP is like a credit spread, reflecting the additional return investors demand as compensation for additional volatility vs. the risk-free asset. /2

The surge in “excess money” (money supply growth less GDP growth) resulting from the fiscal/monetary response to the pandemic has clearly elevated the market’s valuation, as the chart below shows. /3

The rate of change in excess money shows a consistent correlation to the rate of change in the market’s P/E multiple. With that impulse now waning, so has (predictably) the second derivative in the market’s P/E ratio. /4

That surge in valuation brought the ERP down to below-average levels. One simple way to measure ERP is to subtract the risk-free rate (10-year Treasury) from the earnings yield, which I have done in this next chart: /5

With a forward P/E of 22x and the 10yr at 1.3%, the implied ERP is currently around 3.2%. Using a trailing P/E of 25x the iERP is 2.7%. The historical average is around 4.0-4.5%. /6

Another way to calculate the implied ERP (iERP) is using the DCF model. This approach calculates the implied return (and by extension the iERP) based on today’s index level and the historical growth rate in EPS (6%). /7

It’s a more sophisticated approach than just subtracting the RFR from the earnings yield, but it shows the same thing: The risk premium is currently 50-100 basis points lower than the historical average. /8

This chart shows the iERP in blue, the realized ERP in orange. The realized ERP is the CAGR of the excess return between the SPX and LT government bonds. The CAGR for the 1926-2020 period is 4.7%, compared to an average implied ERP of 4.0%. /9

The implication is that at current prices investors are willing to accept a lower excess return for stocks (3.4%) than they have historically been able to earn (4.7%). Lowered expectations could perversely be seen as a symptom of elevated sentiment. /10

Whether this is evidence of a Fed-induced bubble is an open question. It could just be the result of the timing mismatch between price and earnings around cycle inflection points. /11

Because price leads earnings by several quarters, the early-cycle phase tends to be driven by a rising P/E, which can push down the ERP until earnings catch up (mid-cycle). /12

Either way, that 50-100 bps of reduced ERP lowers the denominator of the discounted cashflow and boosts the intrinsic value of the market (and therefore its valuation). /END