American stocks are at their most expensive in decades
Try a little, and it’s never too hard to argue that the stock market looks dangerous and that a crash must be coming. But in the long run it is usually best to ignore such arguments. Since 1900 American stocks have posted an average annual return of 6.4%. Over three decades, that changed the purchasing power of $1,000 to $6,400. Bonds, the main alternative, don’t come close. With an average historical return of 1.7% per year, they generated a modest $1,700. Money would make it worse still.
The lesson for today’s investors, many of whom have been caught up in this year’s bull market, may seem obvious. Don’t forget about a recession that may or may not happen. Just buy and hold stocks, and wait for results that will eliminate any number of short cuts. Unfortunately, there is a catch. What is important today is not historical results but future ones. And on that measure, shares now look more expensive – and therefore lower yielding – compared to bonds than they have in decades.
Start with why stocks tend to outperform bonds. A dividend is a claim on a company’s earnings that stretches into the future, leaving an uncertain outcome. A bond, meanwhile, is a promise to pay a fixed stream of interest payments and then return the principal. The lender could make a mistake; a change in interest rates or inflation could change the value of the cash flows. But the dividend is the riskiest prospect, meaning it must offer a higher return. The gap between the two is “prime equity risk” – the 4.7 percentage points a year that stocks have historically earned over bonds.
What about the coming years? Estimating a bond’s yield is easy: it’s just its yield to maturity. Calculating stock returns is more difficult, but a quick proxy is provided by the “earnings yield” (or expected earnings for the coming year, divided by share price). Combine the two for ten year Treasury bonds and the s&p 500, and you have a crude measure of the equity risk premium that looks forward rather than backward. Over the past year, it has fallen (see table).
Now consider the moving parts of equity risk pricing: earnings, Treasury yields and share prices. Both expected earnings and Treasury yields are close to where they were in October, when share prices hit a bump. But since then dividends have risen sharply, shrinking the earnings yield and bringing it closer to the Treasury’s “safe” yield. This probably means three things. Investors may believe that earnings are going to grow rapidly, perhaps because ai– boosted productivity. They may think that earnings are less likely to disappoint, justifying a lower risk premium. Or they may fear that financials – the yardstick against which stocks are measured – are now riskier.
Steady earnings growth is the dream scenario. The second option, however, is less rosy: that investors have allowed their revived animal spirits to get ahead of them. Ed Cole of Man Group, a fund manager, argues that the price squeeze is a bet on a “soft landing” in equity risk, where central bankers will stamp out inflation. without decline. This has become easier to see as price increases have cooled and most countries have so far avoided recession. But surveys of manufacturers still show a decline in that sector, and the full dampening effect of rate hikes may not have been seen yet.
A third possibility is that instead of moving across stocks, investors are avoiding the alternative. Last year was the worst for bonds both in America (where they lost 31% in real terms) and across developed markets (a 34% loss) in over a century.
After that, says Sharon Bell of Goldman Sachs, a bank, it is not surprising if some investors keep an eye on bonds and tend to splurge on dividends, especially if they believe that inflation has moved structurally higher – shares somewhat, as claims on nominal earnings, protect against, but bonds do not, gain value from fixed coupons. At the same time, governments are to issue more debt to deal with aging populations, defense spending and cutting carbon emissions, while central banks have disappeared as regulators. buy A higher bond yield, and a mechanically lower equity risk premium, will result. This would mean a regime change, to one where the price of equity risk has moved lower in the long term (rather than temporarily, to be corrected by falling share prices).
Whatever the reason for the tension, investors have now placed their bets on rising profits. In a recent analysis, Duncan Lamont of Schroders, an investment firm, compared returns on the s&p 500 going back to 1871 with the yield gap against the Treasury ten years. He found that the relationship “has not been helpful in guiding short-term market movements”. Over the long term, however, there is a clear connection. For a stock starting with a low yield gap to do well over a decade, “the situation is close to being a real earnings growth”. Animal spirits can only take you so far before earnings need to be delivered. It wouldn’t take long for even a long-term investor to conclude that today’s market is overpriced. ■
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