US stocks at most expensive relative to bonds since dotcom era
Tech-fuelled equity rally throws up red flag on ‘Fed model’ for comparing valuations
US equities have soared to their most expensive level relative to government bonds in a generation, amid growing nervousness among some investors over high valuations of megacap technology companies and other Wall Street stocks.
A record-breaking run for US equities, which hit a fresh high on Wednesday, has pushed the so-called forward earnings yield — expected profits as a percentage of stock prices — on the S&P 500 index down to 3.9 per cent, according to Bloomberg data. A sell-off in Treasuries has driven 10-year bond yields up to 4.65 per cent.
That means the difference between the two, a measure of the so-called equity risk premium, or the extra compensation to an investor for the risk of owning stocks, has fallen into negative territory and reached a level last seen in 2002 during the dotcom boom and bust.
“Investors are effectively saying ‘I want to own these dominant tech companies and I am prepared to do it without much of a risk premium,’” said Ben Inker, co-head of asset allocation at asset manager GMO. “I think that is a crazy attitude.”
Analysts said the US’s steep equity valuations, labelled the “mother of all bubbles”, were the result of fund managers clamouring for exposure to the country’s buoyant economic and corporate profits growth, as well as a belief among many investors that they cannot risk leaving the so-called Magnificent Seven tech stocks out of their portfolios.
“The questions we are getting from clients are, on the one hand, concerns about market concentration and how top heavy the market has become,” Inker said. “But, on the other side, people are asking ‘shouldn’t we just own these just dominant companies because they are going to take over the world?’”
The traditionally constructed equity risk premium is sometimes known as the “Fed model”, because Alan Greenspan appeared to refer to it at times when he was chair of the Federal Reserve.
However, the model has its detractors. A 2003 paper by Cliff Asness, founder of fund firm AQR, criticised the use of Treasury yields as an “irrelevant” nominal benchmark and said the equity risk premium failed as a predictive tool for stock returns.
Some analysts now employ an equity risk premium that compares stocks’ earning yield to inflation-adjusted US bond yields. On this reading, the equity risk premium is also “at its lowest level since the dotcom era”, said Miroslav Aradski, senior analyst at BCA Research, although it is not negative.
The premium could even understate how expensive stocks are, Aradski added, because it implicitly assumes that the earnings yield is a good proxy for the future real total return from equities.
Given that profit margins are above their historic average, if they were to “revert towards their historic norms, earnings growth could end up being very weak”, he said.
Some market watchers look to altogether different measures. Aswath Damodaran, professor of finance at the Stern School of Business at New York University, is sharply critical of the Fed model and said the right way to compute the equity risk premium was to use expectations of cash flows and cash payout ratios.
By his calculations, the equity risk premium has declined over the past 12 months and is close to its lowest level in the past 20 years, but is “definitely not negative”.
Equities’ valuation relative to bonds is just one measure of exuberance cited by managers. Others include US stocks’ price-to-earnings valuation against their own history or compared with stocks in other regions.
“There are quite a few red flags here that should make us a bit cautious,” said Chris Jeffery, head of macro at Legal & General’s asset management division. “The most uncomfortable one is the difference between the way that US equities and non-US equities are priced.”
Many investors argue that high multiples are justified and can be sustained. “It is undeniable that [US stocks’ price-to-earnings] multiple is high relative to history, but that doesn’t necessarily mean that it is higher than it should be, given the underlying environment,” said Goldman Sachs’ senior equity strategist Ben Snider.
On Goldman’s own model, which suggests what the PE ratio for the US blue-chip equity index should be, after taking account of the interest rate environment, labour market health and other factors, the S&P is “in line with our modelled fair value”, Snider said.
“The good news is that earnings are growing and, even with unchanged valuations, earnings growth should drive equity prices higher,” he added.
US stocks have now regained all the ground lost during a fall since December. That sell-off highlighted some investors’ concerns that there was a level of Treasury yields that the stock market rally could not live with, because bonds — a traditional haven asset — would appear so attractive.
Pimco’s chief investment officer said this week that relative valuations between bonds and equities “are about as wide as we’ve seen in a long time”, and the same policies that could take bond yields higher threatened to hit stocks.
For others, US stocks’ declining risk premium is just another reflection of investors piling into Big Tech stocks and the risk that concentration in a small number of big names poses to portfolios.
“Even though the momentum is strong on the Mag 7, this is the year where you want to be diversified on your equity exposure,” said Andrew Pease, chief investment strategist at Russell Investments.
