My colleague Andrew Crawford raised the issue of the equity risk premium (ERP) in one of Cumberland’s morning strategy calls. Andrew’s question has prompted us to write this commentary and share it with readers. Some Cumberland Advisors clients already know some of these details, since we have used them for decades when applying the ERP concept to portfolio management.
Here’s a 2013 research paper about the equity risk premium: “A Review of the Equity Risk Premium,” https://www.mercer.ch/content/dam/mercer/attachments/north-america/us/review-of-equity-risk-premium-mercer-october-2013.pdf .
Statista provides a chart depicting the ERP since the Great Financial Crisis. This is, of course, a calculation obtained during a time when the risk-free interest rate was very low or near zero. The impact on the ERP of near-zero interest rates may be huge since very low interest rates cause the ERP to shrink and cause the asset price valuations to rise. Example: at a zero interest rate the theoretical asset price is infinity. See “Average market risk premium in the United States from 2011 to 2022,”
https://www.statista.com/statistics/664840/average-market-risk-premium-usa/ (A subscription is required.)
For a graphical depiction of the ERP since 1979, see “S&P 500 Equity Risk Premium,” https://www.yardeni.com/pub/stockmktequityrisk.pdf. You can see how the ERP has declined by about 50% since the Great Financial Crisis (2008-2022). Hat tip: Ed Yardeni.
Finally, this research paper on the ERP combines information from 20 different models. It’s good for background. “The Equity Risk Premium: A Review of Models,” https://www.newyorkfed.org/medialibrary/media/research/epr/2015/2015_epr_equity-risk-premium.pdf?la=en.
Now, let’s get to today.
Here’s a simple metric. As this commentary is being drafted, the consensus earnings estimate for the S&P 500 Index is currently running around an annualized price/earnings ratio of 18.5. We’re rounding numbers for simplicity and not quibbling over a few basis points.
Divide the number 1 by 18.5, and you obtain an earnings yield for 2023, estimated at 5.4%. That means that an investment in the S&P 500 basket of stocks on a cap-weighted basis would return 5.4% in earnings at the market prices of all 500 stocks today (dates of drafting this commentary are about 1 week ago). The collective basket of those 500 companies would then either pay dividends, buy back stock, reinvest those earnings in the company for growth, reduce company debt, or use cash flow generated by the earnings for a merger or an acquisition. In fact, all the above happen with those earnings. And all those actions involve risks of some type.
Now let’s use the traditional 10-year US Treasury (on-the-run) note, a debt instrument, which is deemed to be a riskless alternative. Let’s assume that the interest rate is 3.8%, (as this commentary was being drafted). So, you can get 3.8% for 10 years with no risk, or you can get 5.4% for the next year and an unknown (but estimable) return after that if you use the S&P 500 cap-weighted index as your reference. The difference between the two (1.6%) is the equity risk premium for a 10-year time horizon with a 1-year outlook, followed by a rising uncertainty risk premium over time in years 2, 3, and 4, etc.
We have been using this technique to value the US stock market for nearly half a century. So have many other practitioners.
Let’s make the technique more complex so readers can understand why there are different models or versions of ERP.
The time horizon can vary. Essentially, the analyst may select any time horizon and apply the principles. If the portfolio structure is geared toward shorter-term investment horizons, the equity risk premium evaluation technique must be modified for that purpose. The reverse is true for very long-term time horizon funds like pension systems.
The same holds true for sectors. For example, would you use the same ERP valuation techniques for utilities, which are regulated and have predictable longer-term rates of return, as you would for high-tech growth companies? The answer is no.
Some practitioners are rigid about the “correct” or “desired” ERP. We are not. Because we are a separate account manager and not just one big fund, we must be flexible. We can alter the risk profile to suit a client, and that means thinking differently about how to apply the ERP. As a result, the application of ERP becomes even more complicated.
Here’s an example. The client is a high-tax-bracket individual in the United States. That means the portfolio is taxed at a presumed rate of 37%, or at the current long-term capital gains tax rate, or at the longer-term estimate of the trust or estate tax rate. So what do we use for a riskless interest rate? Do we use a 10-year US Treasury note and apply the tax to it? Or do we use a very-high-credit-quality tax-free muni rate and apply the ERP formulation to it?
Readers might say, “Wait a minute! You’re comparing an apple with an orange.” Our answer is no, we’re not. For example, we can use a pre-refunded muni that is secured by an escrow of Treasury securities so that the interest rate is still riskless. Or we can use a tax-free housing authority muni bond that is secured by a basket of mortgages guaranteed by the federal government (an agency like FNMA or GNMA). Riskless doesn’t always mean just US Treasury bills, notes, or bonds.
Here’s another example. The portfolio is in a larger IRA and is subject to annual required minimum distributions (RMD). The age of the client is known, and the time horizon is estimable from mortality tables. The IRA is not taxed. So, the riskless reference can be the US Treasury yield curve, and the ERP time horizon can be the weighted average of the forecast path of the RMDs. Now, this application is even more complex because of the multiple time horizons. But it is taking the ERP concept and personalizing it for the client. Example — if a person has a Roth IRA and has additional wealth such that they never expect to invade the Roth IRA and plan to leave it to their heirs without taxation, the outlook is much different than for a traditional IRA that is facing rising RMDs as the client ages.
Let’s get to where we think the stock market is today.
Our assumption is that the uncertainty premium is higher than normal, given current worldwide central bank policy risk, inflation forecast uncertainty, a shooting war that is expanding, a worldwide financial sanctions and payments war, and a destructive and divisive political culture war that negatively impacts American policy. And let’s not forget that residual pandemic risk remains: 40,000 Covid cases and 300 dead people a day in the US (the approximate death rate last week from the CDC) confirm the risk. These factors combine to raise the uncertainty risk assessment of the future.
So, the higher the uncertainty premium which we cannot measure, the more ERP is needed to compensate for that higher risk. This is the intersection where a portfolio manager morphs from math to judgment and experience.
At the same time, interest rates have decidedly departed from their zero lower boundary. All the negative interest rates around the world have disappeared. And the forecasted pathway of future interest rates is directionally higher, not lower.
Consequently, the riskless interest rate is putting pressure on the estimate of the appropriate ERP while the earnings yield is more difficult to forecast and becoming more problematic because of the risk factors.
In our judgment, a more appropriate ERP in today’s world is closer to 3%–3.5% than it is to the 1.6% we calculated in the example above. That estimate is only one week old. And this estimate is an opinion. So, we will have to own the outcome from making it.
A 3% or 3.5% ERP may not be enough to encourage investment in equities; only the future will show us if it should have been even higher today. One thing seems clear to us. While it may be even higher, it certainly is not likely to be lower. So that that leads us to guess that the current stock market is priced too high because the current estimate of an ERP using the cap-weighted S&P 500 is too low.
We may be wrong, and this too-low ERP will be improved by higher earnings from those companies. Or it may be helped by a declining interest rate. Or a combination of both. But we must remember that the ERP can be worsened by the opposite outcomes.
Because we believe the stock market is priced too high relative to the risk, we are holding a cash reserve in our US Equity ETF portfolio. The current use of our ERP technique suggests that some cash reserve is warranted.
Also, note that the cash now earns 1% a quarter instead of zero and is nearly instantly available for deployment if investment opportunities present themselves. Let’s add the observation that some practitioners using the ERP technique are forecasting an S&P drop in price to about 3000. Some others see it falling to 3600 or 3200 or other levels. We note that no practitioner is forecasting a positive investing environment for equities that features a shrinking ERP until after the uncertainty risk described above becomes less murky.
We like our cash holdings in our US Equity ETF portfolio strategy.
David R. Kotok
Chairman & Chief Investment Officer
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