The tall man eats dinner every Tuesday at the same restaurant on 58th St. in NY. He loosens his bowtie after working late on Tuesday nights; he sits at his usual table; he orders the usual meal from the same waiter who has served him for the last 14 years. The waiter, Demetrius, brings the bowl of avgolemono soup and a glass of chilled Assyrtiko from Domaine Papagiannakos. The wine’s history goes back to Sparta in the time of Ancient Greece. The soup is a classic signature dish.
The waiter turns to leave. The man says, “Dima, wait!” The waiter returns. “Dima, please taste the soup,” says the man.
“Is it too cold?” asks Dima.
The man repeats the question: “Taste the soup.”
Dima: “Too much salt?”
“Taste the soup!” This time there is a smidge of pique in the man’s voice, and the word please has disappeared.
The waiter succumbs; he says, “Okay.” He looks down at the table.
“Where’s the spoon?” Dima asks.
“Aha!” says the tall man.
Moral: You cannot evaluate something without the proper tool.
ERP is a tool. The stock market is the soup.
The NY Fed has a recent (December 21, 2020) paper out on the equity risk premium (ERP): “What’s up with Stocks?” https://libertystreeteconomics.newyorkfed.org/2020/12/whats-up-with-stocks.html.
We recommend this paper to all serious investors.
There are many ways to estimate ERP. Various research papers have noted 20 distinct methods. We are not going to dissect them here. We use several of them at Cumberland.
Our takeaway from this NY Fed paper is how most methods are pointing to a consistent conclusion. The reason lies in the persistent view that interest rates, on riskless government paper, are likely to stay low for a long or even a very long time. As long as the riskless interest rate or other reference interest rate stays low, as it is today, the stock market can go higher based on the estimates of earnings. Maybe the market goes much higher, since it is the speed of the economic recovery and the robustness of that recovery that will determine those earnings.
Let’s take apart the ERP equation.
The first and easier part is the riskless interest rate. We know the short-term rate is near zero. We know the intermediate term rate is about 1% (10-year Treasury). And we know the long-term rate is under 2% (30-year Treasury). Fed Chairman Powell has said that those rates will be around for a while (2–3–5 years?) and that they are not likely to rise by very much until certain inflation and employment metrics are reached.
The Fed has also given us the inflation metric (above 2% on a sustained basis as measured by the PCE). Powell, Clarida, and others on the FOMC have affirmed that view.
Secondly, the employment metric is fuzzy because of the jobs-counting mechanism we use. If the unemployment rate is 6 points lower than it was at COVID peak level BUT the decline is due to 10 million workers dropping out of the labor force (lowering the labor participation rate), then to use the old unemployment-rate metric is a flawed approach. We need to think about using metrics for a “100-year-flood” type of event. And we do know that the employment metric needs millions more jobs actively filled before it gets to a level where the Fed will change policy.
So for ERP purposes, the range of interest rates to use in valuing stocks is 0.0% short, 1.0% intermediate, and 2% long. Let’s keep it simple and use those three metrics.
Okay, what about the earnings?
That is harder. We will use the S&P 500 Index, since it is the most widely used reference and we can estimate the range of its earnings. For 2021, the range of estimates for the year is wide; we will call it $170–$190. We won’t have a better estimate until the vaccine rollout gets to full force and the recovery starts gaining momentum robustly.
Let’s focus on 2022.
We have an indication that corporate taxation will increase. The Biden administration will have the votes to pass the budget funding annual continuing resolution, if they cannot get the votes sooner. So we are factoring in the change in taxation and reducing our estimate for 2022 earnings to a range of $200–$220. Let’s use the lower number of $200 for caution’s sake.
Okay, $200 earnings and an interest rate discounting mechanism of 0.0% or 1% or 2%.
No matter what rate you use, the resulting ERP suggests much higher stock prices. For example, $200 earnings at a 4% earnings yield suggests a 5000 level on the S&P 500. At an interest rate assumption of 1%, that is a fairly priced level using this simple example.
But the other metric is the annual growth rate of those earnings. We think the best estimates of that growth rate are now ranging in the high single digits. Let’s use a range of 5%–8%. We think this range is reasonable given the degree of demand from the COVID shock recovery and the massive infusion of monetary and fiscal policy that has been applied to offset the damage from that shock. We are assuming that Biden gets most of his stimulus request.
Because the interest-rate metric is so low, the growth rate of the earnings becomes a dynamic element that is quite powerful: $200 becomes $210 and then $220, etc., as the year-after-year trend of rising earnings takes them so much higher than the interest rate is projected to be. Therefore the compounding of earnings growth becomes a powerful force for higher stock prices.
Our conclusion: The medium term (2–4-year outlook for the S&P 500) is a level of 5000. The longer-term (5–8-year) outlook is 7000–8000. And, while we wait, the dividend yield is likely to equal or exceed the riskless interest rate.
We admit that this is a very bullish strategic outlook for stock prices. We admit that many developments could derail it. We could have a war, and we have just had a huge shock with the pandemic. And we admit that this is a mathematical exercise to derive the estimates.
Avgolemono is a thick soup. It is best served hot and is delicious. To eat it, you need a spoon, not a straw or chopsticks. Selecting the right tool is important.
For stock prices and a strategic view, we use the best tools we have. That is why our US ETF accounts continue to be nearly fully invested. Our quantitative strategies adjust cash balances and are trading-related, so there may be some cash in specific client accounts.
David R. Kotok
Chairman of the Board & Chief Investment Officer
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