U.S. equities cheap for a reason
By most measures, US equities are not cheap. Yet many investors remain overweight, believing that in a world of ultra-low interest rates and negative bond yields, equity valuations should be higher because future cash flows are now discounted at a much lower rate than in the past. At first glance, the equity risk premium — the expected return on stocks over and above the risk-free rate — appears to support this belief. At more than one standard deviation above its long term average, history suggests the equity risk premium should revert towards its mean, implying further valuation gains are probable. Alas, we cannot share this optimism.
The precise definition of the equity risk premium is the subject of endless academic debate. For this discussion, we use dividend yields compared to real long term bond yields. The reason dividend yield is our preferred numerator is that earnings yield, the other commonly used measure, assumes undistributed profits can be reinvested at current earnings yields, which may be unrealistic. And we use real bond yields because dividend yields are perceived as a “real” rather than a “nominal” measure. By this formula, the US equity risk premium is currently one standard deviation above its 50year average — and has been at this elevated level ever since September 2011, when the Federal Reserve launched Operation Twist to drive down the long end of the curve.
This isn’t the first occasion the equity risk premium has remained abnormally high for an extended time. In the last 100 years, there have been three such periods. Episodes of elevated equity risk premiums were associated with both the First and the Second World War, while the third period coincided with the era of Keynesian policies in the late 1970s, even though corporate earnings were growing rapidly at the time.
What these three episodes have in common with each other, and with today, is that each coincided with a period of negative real interest rates. Of course, there have been other interludes of negative real rates in the last 100 years, and in those too the equity risk premium rose. But because the starting points were generally lower and the duration of the episodes shorter, the equity risk premium neither got so high, nor remained elevated for so long, as today.
So why does the equity risk premium go up and stay up when the Fed is being accommodative? Two possible explanations spring to mind:
1) Investors regard central bank policy counter-productive and unsustainable.
During the 1970s, as Keynesian policies pushed inflation higher, investors gave more weight to mounting long term uncertainties than to rising earnings growth. Today with the Fed again in Keynesian mode, investors again fear a policy mistake. Few share the Fed’s belief that artificially depressed interest rates will persuade people to bring forward future demand, which in turn will encourage entrepreneurs to invest more. Instead, investors worry that a false cost of capital makes an unstable foundation for financial markets, and that the longer it persists, the greater the risk of an unhappy ending.
2) Investors regard the current ultra-low interest rate policy as an acknowledgement of the structural weakness of the economy, and of the ineffectiveness of monetary
policy to remedy the situation.
Time and again, the Fed has been forced to extend its unconventional policy, a signal that the current cycle is abnormal and that the economy could be sinking into a secular stagnation. Yet after almost eight years, there is little sign that the unconventional policy is working. For investors, a real rate kept low by stagnation is no cause for celebration.
If there is any truth to these explanations, US equities are an unattractive investment despite their high risk premium. What’s more, this argument does not apply solely to the US. Other major developed markets have seen similar widening of their equity risk premiums, starting from the times their central banks decided to embark on easy monetary policies. The obverse of this trend is that in recent months safe haven investments such as the yen, gold and sovereign bonds have all rallied significantly, emphasising the conservativism of investors.
At its heart, the question “are equities cheap?” centers around the implications of low interest rates. Bulls justify their view by citing low interest rates as the reason to reduce the discount rate they apply in their models of future earnings, so pushing up the present value of equities. But if central banks are right to worry about growth (and indeed if central banks are themselves the cause of worries about growth) then profits will continue to disappoint, and an even lower discount rate will be needed to offset cash flow forecasts that keep getting revised downwards. Perhaps there is still room for the discount rate to go even lower, but the very fact that investors are relying on a constantly falling discount rate to justify their positions is itself a cause for considerable concern.