After being written off as negative for the past decade, the equity risk ratio, a measure of the potential rewards investors will reap from buying stocks, has fallen to its lowest level since 2007.
For some, this means U.S. stocks are not worth the risk right now that investors can reap returns of 5% or more by buying short-term Treasurys and other high-value bonds.
In the years following the financial crisis, many investors abandoned ERP as U.S. stocks became increasingly dependent on real estate, their value boosted by the Federal Reserve’s set national interest rates.
Some investors have a name for this phenomenon: TINA, which stands for “There Is No Alternative” – meaning that, with the amount of money earned on the ground, investors are very interested in putting the money them to work in the stock market.
Now the situation has reversed. As inflation and expectations of a more difficult economic environment weigh on expectations of corporate profits, the almost guaranteed return on Treasurys has increased. This means the equity risk ratio is once again useful as a measure of relative value for stocks, since it can provide a helpful indication of what investors stand to gain over the short term by taking the added risk that comes with buying stocks, or investing in them. shares.
ERP accounting methods are different. Some economists like to include a measure of inflation in their calculations to produce what is known as a “real” risk factor (“real” in this case means the figure is adjusted for inflation, which removed from the connection used in the calculation). .
How to calculate the value of equity risk
Others simply use analysts’ forecasts of how much S&P 500 companies are expected to earn in the next 12 months.
As of late Friday, the equity risk ratio stood at 1.7%, according to FactSet data.
Investors can arrive at this figure by taking Wall Street’s projected annual earnings for the S&P 500 — in this case $221.68, according to FactSet data — and dividing it by the S&P 500’s level, which it stood at about 3,970 as of Friday’s close. The result is multiplied by 100, to arrive at about 5.6%. Investors subtract the current risk-free rate — in this case, the 10-year yield, which stands at 3.920% — to arrive at the final figure.
“This is not the case,” said Liz Young, head of investment strategy at SoFi, who spoke to MarketWatch after sharing the ERP chart on Twitter.
“Basically, what it’s telling you is you have to pay a lot for that level of risk,” Young said, referring to U.S. stocks. “It’s not a great entry point for a variety of reasons.”
What does this mean for the market?
While a lower ERP may be good news for bonds, it may mean that investors willing to wait out the chaos may walk away with a better deal. That’s because historically, small ERP has been associated with recessions and bear markets, says former New York Fed economist Fernando Duarte, who wrote about ERP in a 2015 paper and on his blog New York Fed from December 2020.
Although the U.S. economy is not in recession and U.S. GDP growth has been strong, the S&P 500 entered market territory last year. The large-cap index is still down about 17% from 4,796.56, its record high, reached on Jan. 3, 2022, according to FactSet.
Meanwhile, investors looking to outperform the market will need to be careful when deciding which stocks to buy. Young people and others expect companies with business resilience, low debt and the ability to continue to generate money even when the economy is shaken to succeed.
“Knowing how other companies make their profits, and what those profits or cash flows are, is going to be important,” said Callie Cox. US investment analyst at eToro, during a phone interview with MarketWatch.
Steve Eisman, the former hedge fund manager famous for his “Big Short,” said Monday that he is buying bonds “for the first time in a long time.” Although technology stocks have led the market’s resurgence since the beginning of the year, Eisman believes that the days of banking market returns by investing in technology stocks are over.
U.S. stocks rose after suffering their biggest weekly decline on Friday. S&P 500 SPX,
rose 0.5% late Monday in New York after ending the week down 2.7% on Friday, according to FactSet data. The Dow Jones Industrial Average DJIA,
rose 57 points, or 0.2%.
Treasury yields, meanwhile, have pulled back slightly, but the 10-year yield TMUBMUSD10Y,
it’s still on track to cross over 4% from the start of last fall. It stood at 3.920% Monday, down 2 points on the day.
#Buying #shares #worthless #today #analysts #return