Uncertainty about the policy path amid still too high inflation is driving another bout of macro-driven market moves. The backup in bond yields has left the traditional equity risk premium measure (the spread between the S&P NTM earnings yield and US 10yr yield) at its lowest level of the post-GFC era, despite relatively stable earnings and a 4.5 points of PE contraction. The result has been concerns of a sharp downturn and a retest of the market low. BUT looking at the equity risk premium based on a discounted cash return equity risk premium shows investors have discounted far more uncertainty.
The sharp divergence can be explained by exceptionally high inflation. The spread between the S&P earnings yield and REAL 10yr yield has climbed to the upper end of its post-GFC range, consistent with the backup in the cash return discounted equity risk premium. Inflation is biased lower over the next year, and even without any change in the market, that will narrow the real versus nominal equity risk premium.
Applying a 5.5% equity risk premium, roughly the median level in the post-GFC period, puts S&P fair value at 4210, or 6.8% higher than yesterday’s close. There is downside risk to earnings estimates, and Macro uncertainty is still elevated so narrative shifts will continue to push markets around near-term. Even with those considerations, the fair value range on the market argues against a breakdown to new lows.
At the sector level, the current equity risk premiums are lower across all sectors relative to September, especially for deep Cyclicals. The composition of cash return is important when thinking about sector-level fair value. Communications yield is skewed toward buybacks, which are likely to slow much more significantly than dividends in the event of a recession. That reinforces the importance of focusing on companies with high pricing power (HERE) and names with high earnings and cash return sentiment (HERE).
At the end of the report, we run through the S&P fair value calculation under a 5.5% equity risk premium scenario with the consensus EPS estimation. We can run this analysis for any set of earnings estimates/cash return/10yr yield assumptions. Let us know if you would like a scenario run.
Working Through Fair Value Frameworks: Uncertainty about the policy path amid still too high inflation is driving another bout of macro-driven market moves. The backup in bond yields has left the traditional equity risk premium measure (the spread between the S&P NTM earnings yield and US 10yr yield) at its lowest level of the post-GFC era, despite relatively stable earnings and a 4.5 points of PE contraction. The result has been concerns of a sharp downturn and a retest of the market low. BUT looking at the equity risk premium based on a discounted cash return equity risk premium shows investors have discounted far more uncertainty.
The sharp divergence can be explained by exceptionally high inflation. The spread between the S&P earnings yield and REAL 10yr yield has climbed to the upper end of its post-GFC range, consistent with the backup in the cash return discounted equity risk premium. We prefer the equity risk premium measured by discounted forward cash return as it accounts for dividends and net buybacks. Total cash return has become a large part of expected market returns.
As inflation has trended lower recently, macro risk moved lower, and implied volatility for equity, bonds, and currencies all dropped. Historically, the implied ERP has been positively correlated with the VIX. Macro uncertainty is still elevated and until 4Q earning season starts next month, relatively sparse macro data and narrative shifts will continue to push markets around. But assuming a deep recession is avoided, lower volatility should bias the equity risk premium lower over time.
Using consensus EPS estimates, an equity risk premium higher than 6% would lead to and S&P fair below the current level of the market. Applying a 5.5% equity risk premium, roughly the median level in the post-GFC period, puts S&P fair value at 4210, or 6.8% higher than yesterday’s close.
At the sector level, current equity risk premiums are lower than normal across all sectors, especially deep Cyclicals. Energy remains the sector with the highest equity risk premium (and the greatest macro influence) while REIT’s equity risk premium is lower than all other sectors.
Cash return yield (dividend yield and net buyback yield), which is a major input into the implied ERP calculation, shows Communications, Energy, and Materials are the greatest total yields, while REITs, Utilities, and Discretionary have the lowest. The composition of cash return is important when thinking about sector level fair value. Communications yield is skewed toward buybacks, which are likely to slow much more significantly than dividends in the event of a recession. That reinforces the importance of focusing on companies with high pricing power (HERE) and names with high earnings and cash return sentiment (HERE). Defensives are generally more dividend skewed, confirming that they would be relatively attractive in the event of a deep recession.
Below we walk through the current S&P fair value calculation under a 5.5% equity risk premium with consensus EPS estimates. The discounted forward cash return leads to the estimated S&P fair value at 4210. We can run this analysis for any set of earnings estimates/cash return/10yr yield assumptions. Let us know if you would like a scenario run.
