Published November 3, 2023
Below is a brief discussion from Delta Research on the risk premium that stocks are currently offering. With U.S. Treasury bonds (aka the “no risk” asset) yielding 5%+, for the first time in years, bonds are a solid competitor to stocks.
Investors buy “risky” assets because they believe the excess return will be sufficiently attractive to make the risky asset a better-buy than the low/no-risk asset. All investing requires predictions about the future and as a result, an element of risk. To improve the likelihood of achieving attractive portfolio returns, we use probabilities and math to form calculated risk expectations about future returns.
Unfortunately for risk assets currently, the math is not adding up. In very simple terms, risk-free ultra-short duration U.S. treasuries pay a yield of about 5.3%. The S&P 500 earnings/yield is about 5.3%. The math says you are not being paid excess return to invest in risky stocks versus low risk, short-duration treasuries.
The chart below shows the difference between the S&P 500 earnings yield and the 10-year treasury touched zero in October for the first time in about twenty years.
The excess return from buying risky assets is called the Risk Premium. The risk premium over the past 10-years through the end of 2022 averaged about 4%. The average annual return of the S&P 500 without dividends reinvested was 10.6% during. When the risk premium is near zero, as it is now, it is reasonable to expect lower returns from risk assets.
The three variables that can restore higher expected excess return to the stock market are:
• Lower risk-free interest rates, and/or
• Higher earnings estimates, and/or
• Lower stock values.
The Federal Reserve kept the Fed Funds rate unchanged this week at 5.25-5.5%. Following the Federal Reserve’s press conference on Wednesday, investors interpreted Fed Chairman Powell’s remarks as no more rate hikes and a high likelihood for two rate cuts over the next twelve months. The 2-year treasury yield declined from 5.08% to 4.94%. The 10-year yield fell from 4.91% to 4.63%. The stock market rallied on lower rates.
Coming into earnings season, consensus analyst estimates had S&P 500 earnings down by as much as 4.4% year-over-year in the third quarter. With over 50% of the S&P 500 companies reporting, the actual earnings growth for the quarter is a positive 2.7%.
From the beginning of August to the low of October (last Friday) the S&P 500 index depreciated by about 10%. The forward P/E of the S&P 500 is 17.1x, which is below the 10-year average of 17.5x.
Interest rates may have peaked, earnings currently are showing growth and stock valuations are lower. These are positive factors for risk asset valuations and may enable the S&P 500 to find support near its current level.
For what feels like a long time, investors have lurched from one Federal Reserve meeting to the next looking for clues about the future direction of interest rates. This week, the specific question is whether rates are done moving up and have peaked at 5%. Almost everyone expected the Fed to stand pat in their meeting this week. It was the tone of the Fed that would be the source of any angst. Monday brought a +1% rebound after two weeks of poor market performance left most stock market indexes at break even or worse for the year. The advance, an apparent relief rally after the prior week’s selloff, came despite a tick higher in interest rates and a -4% slide in oil prices. Stocks added +0.6% Tuesday as a losing month of October came to an end. It was the third straight month of losses for stocks. Global manufacturing bellweather Caterpillar slid -7% as the negative market environment continues to pound stocks whose earnings outlooks do not surprise to the upside. The Fed held rates steady as expected Wednesday while Fed Chair Powell’s words soothed investors. The market rose +1.1% with bond yields pulled downward when Powell suggested the Fed would be in wait-and-see mode for awhile given how far rates have already moved. The U.S. Treasury added to the upbeat tone by announcing a heavier focus on short-term debt in upcoming auctions, thus taking the pressure off long-term interest rates. Stocks ran harder on the Fed’s rate pause in Thursday’s session with investors removing short market bets and stocks pushing almost +2% higher. The flip in the market script was evident in the reactions to earnings as well. Whereas stocks were getting pummeled the prior two weeks for any caution in their outlook, the post-Fed earnings reactions were completely opposite. For one, Starbucks ripped +10% higher on notes of expansion while TV streamer Roku jumped +30% on earnings – moves that likely would have been far more subdued only a week earlier. The good cheer continued Friday when the monthly jobs report came in softer than expected. The nudge upward in unemployment and reduction in the pace of hiring added further conviction to the camp that believes interest rates have peaked. Stocks added a further +1% Friday while interest rates continued giving back recent moves higher. Whether stocks can build on this week’s rebound, or whether it was just a relief rally destined to ultimately fail will be answered as we move into November. Bulls will be looking for the usual seasonal uptick to continue.
Stocks finally heard what they wanted from the Fed leading market indexes to shoot sharply upward. The S&P 500 (SPY) added +5.85% to regain all that was lost the prior two weeks. Same for the Nasdaq 100 (QQQ) which gained +6.49%. Smallcap stocks (IWM) recouped almost four weeks of losses with a +7.57% vault.
Warm wishes and until next week.