Two economists at the Federal Reserve Bank of New York, Fernando Duarte and Carlo Rosa, recently wrote in a posting on the bank's website that most stock forecasting models point to historically high excess returns for the S&P 500 (SPY) over the next five years. Even with the broad domestic equity gauge trading at its all-time high, further gains could well be in hand for the market according to these forecasters.
How did these economists reach this conclusion? In conversations with banks, other central bank economists, and academics, the researchers analyzed twenty-nine of the most commonly used models to calculate the equity risk premium over the trailing fifty years. Taking the weighted average of the twenty-nine models for the one month forward equity risk premium produced a graph that appears quite telling.
Today's equity risk premium is as high as it has been over the trailing fifty years. Previous peaks in November 1974 and January 2009 corresponded with tremendous forward returns for the equity market. Stock market participants today would happily take the forward returns experienced from these market points as tabled below.
Each of these historic periods featured tremendous uncertainty. In the winter of 1974, the economy was mired in a bout of stagflation driven by the exogenous shock of the oil embargo instituted by OPEC the previous year. Unemployment peaked at 9%, and inflation peaked at 12.3%. The U.S. produced negative real GDP in 1974 and 1975, the first full year negative prints since 1958.
January 2009 was just four months after the collapse of Lehman Brothers triggered a global financial meltdown triggering rolling recessions throughout the developed world. Economic growth collapsed in the last quarter of 2008, and the stock market troughed in March of 2009 at just 43% of the nominal level of its high from seventeen months earlier. The 2008-2009 two year period marked the first consecutive annual drops in real gross domestic product since the aforementioned 1974-1975 period and marked the biggest reduction in real economic growth since the end of World War II.
Equity markets were in the midst of severe corrections during each of these historical periods, but were nearing a local peak in December 2012, the terminus of the Fed study. So why is the current market environment signaling a similar high equity risk premium? Low nominal interest rates in the United States are driving this market signal.
In "Equity Multiples and Interest Rates: Is the Current Risk Premium Sufficient," an article that was named one of the best Seeking Alpha articles of all-time as chosen by other authors, I wrote in March 2012 that since the value of a stock today is its future earnings or shareholder dividends discounted back to the present, then the earnings yield (earnings/price) should be a function the discount rate. At that point in time, the earnings yield was trading at a historically large gap to the Treasury yield curve. The S&P 500 responded with a 22.5% return over the next fourteen months. On the date of that article, the earnings yield of the S&P 500 was at 7.04% and the ten-year Treasury yield was at 1.99% for an equity risk premium of 5.05%. Today, the earnings yield is lower given the multiple expansion of the index from 14.2x trailing earnings to 16x trailing earnings, an earnings yield of 6.25%. Treasury yields are lower today than they were at the beginning of March 2012 with the ten-year Treasury at only 1.9% even after the 20bp month-to-date selloff. This translates to an equity risk premium of 435bps, which is still historically high even after the impressive equity rally we have experienced.
Of course, the equity risk premium is about expected returns and there could still be tremendous variability around realized outcomes. The question is whether this equity risk premium is sufficient compensation for the uncertainty embedded in this risk premium. We have never seen this level of extraordinary monetary accommodation from the employers of the aforementioned study or other global central banks. The ultimate impact of the unwind of this experimental monetary policy is uncertain as is the effect these policies will have in counterbalancing fiscal austerity necessary to curb the debt fueled excesses enjoyed by households, corporations, and governments over the trailing generation. The developed world is also aging rapidly, and demographics have also had a major impact on earnings multiples over the trailing fifty years, a signal that equity multiples could compress over the forward generation, hampering returns.
The equity risk premium is also relative to Treasury yields, which are historically low. Asset returns may still be lower than their historical averages while markets successfully capture this equity risk premium, a phenomenon some market pundits have dubbed "The New Normal." Every investor must decide if they are currently getting paid enough, through the equity premium, relative to lower risk alternatives, to accept the aforementioned risks and glean what still might be returns that are below historical norms. Researchers at the Fed signal that the equity risk premium is high, and this has historically led to strong forward returns, especially from previous peaks in this risk premium. I tend to agree, and believe that there are future gains ahead for the domestic equity market. As always, I am interested in hearing reader feedback, and your own thoughts on the equity risk premium and forward return expectations.