Stock investors are getting the worst deal in 23 years … what the ERP and CAPE suggest about forward 10-year returns … despite the red flags, stay in this market … price trumps all
As a 6-year-old, I was certain that the phrase was “the bear of bad news” rather than the “bearer of bad news.”
We begin today’s Digest with me combining the two as the bearer of bearish news…but we won’t end there.
Here’s the bottom line for my initial bearishness.
My bullish friends, the premium that you’re willing to accept today for owning stocks instead of bonds (called the “equity risk premium” or “ERP”) is at its lowest level in 23 years.
In other words, you’re getting a terrible deal when buying the typical stock today.
Rather than enjoying the “risk-free return” of quality bonds held to maturity, you’re in danger of adding “return-free risk” to your portfolio when you buy some very overvalued parts of the stock market.
Let’s fill in a few details on this, but then we’ll switch things up…
I’ll throw off the mantle of “bearer of bearish news” and switch over to the “bearer of reasonably bullish news.”
After all, there are still plenty of fantastic returns available to investors today when looking in the right areas, and with the right perspective.
What the ERP does, and does not, tell us
Most investors don’t like risk…but they do like big returns.
So, investors live with an ongoing tension – the tug of war between how much risk to accept in exchange for some anticipated size of return.
Do you invest in U.S. government bonds that are considered “risk free?” Or do you reach for even greater returns by investing in stocks, knowing that you risk loss of capital?
Investors demand an “equity risk premium” to compensate them for taking this extra risk. We measure this extra return through the ERP.
It compares a stock’s earnings yield (which is the inverse of the price-to-earnings ratio using a company’s expected earnings over the next year) to a bond yield.
So, how much additional return are investors demanding today for stocks over bonds?
Try about 0% on for size.
Here’s our hypergrowth expert Luke Lango:
The 10-year Treasury yield continues to spike, yet stocks do not fall, leading to an Equity Risk Premium (ERP) that is now at a new cycle low of just 0.10.
This figure is far too low.
The S&P 500 should not trade at 23.5 times forward earnings when the 10-year Treasury yield is near 4.2%.
One of these metrics must adjust.
To be clear, this does not mean we’re in danger of a stock market crash at any moment
The ERP is not a market timing tool.
If anything, it’s more of a gauge of investor sentiment. Today’s ERP has fallen toward zero as bullish investors have bid up stock prices, which reduces their earnings yield, making stocks less attractive relative to high-yielding bonds (hence a low ERP).
But we cannot ignore this ERP reading. Studies show that long-term stock market returns often underperform in the wake of very low ERPs.
This makes sense because one of the key variables of the ERP is a stock price. In essence, a low ERP shows, in part, that investors have already paid top dollar for expected earnings going forward.
But if investors are already paying high prices today, that means they’ll have to pay even higher, nosebleed prices tomorrow to keep the bull market going. And at some point, there’s a limit to what people will pay for stocks. It may not be tomorrow, but lofty stock prices and a low ERP are not supportive of a long and healthy bull market.
So, though today’s anemic ERP doesn’t mean “get out of stocks immediately,” it does suggest the typical stock isn’t going to do well over the coming years.
We get the same broad market takeaway when analyzing the S&P’s CAPE ratio
“CAPE” stands for “cyclically adjust price-to-earnings” ratio. It’s a long-term measure of a market’s valuation.
It’s the traditional price-to-earnings ratio of a stock but it uses rolling 10-year average earnings to smooth out business cycle fluctuations.
Like the ERP, the CAPE ratio isn’t a market timing tool. But it does offer investors a helpful and remarkably accurate expectation of long-term forward returns.
This happens because markets tend to mean revert over time. So, a stock or index that has a high CAPE value today is more likely than not to see its value fall in the coming years. That would mean below-average stock returns.
On the flip side, a stock or index that has a low CAPE value today is more likely than not to see its value rise in coming years. And that would be based on above-average returns.
The more extreme the starting CAPE value (either high or low), the more pronounced those ensuing 10-year returns often are.
Below is a chart from my friend and quant investor Meb Faber. Starting in 1900, the chart shows initial CAPE values of the S&P and what the ensuing 10-year returns were after beginning at the specified CAPE value.
Dark green represents the cheapest CAPE starting years (CAPEs between 5 and 10).
Red represents the most expensive (CAPEs between 20 and 45).
As you’ll see visually, most of the “green” starting years (low CAPE ratios) end up on the right side of the chart — meaning big 10-year returns.
On the flip side, “red” starting years (high CAPE ratios) usually end up on the left side of the chart — meaning low and negative 10-year returns.
So, what’s the S&P’s current CAPE value?
33.61 – the second highest level since the Dot Com peak, and deep into the “red” bucket of dangerous starting valuations.
In short, today’s near-zero ERP and nosebleed CAPE say one thing…
The typical stock isn’t likely to perform well over the next 10 years.
This echoes Stanley Druckenmiller of Duquesne Capital, perhaps the greatest trader of all time, who said last year:
If I liked the stock market, I would be exposed to it, and I’m not exposed to it.
[Due to high valuations, elevated profit margins, and fiscal challenges, it is] hard for me to envision stocks being higher in 10 years.
Now, the reality is that Druckenmiller is exposed to this market. He owns a fair amount of Nvidia and Microsoft among other stocks.
So, perhaps a more accurate rewrite of his comment would be “I’m not exposed to this broad market. I’m being very selective in what I own.”
And that’s where we begin to pivot today’s Digest from bearish to bullish.
In this market, you don’t want ho-hum stocks littering your portfolio. You want to focus on stocks with earnings strength, primed to continue growing in today’s shifting economy.
But you do want to be invested today – absolutely. There’s simply too much strength out there not to be taking advantage of it.
What the low ERP isn’t telling you
We all know that Big Tech – most notably, the Magnificent Seven – have enjoyed enormous price run-ups over the last 12 months.
And we know that these Mag 7 stocks have a massive influence on the overall S&P due to their heavy weightings within the index.
So, what would happen to the red-flag ERP value if we used the S&P 500 Equal-Weight Index in our calculation rather than the traditional weight-averaged S&P Index?
Fortunately, Luke has crunched the numbers for us:
[The low ERP and its implied overvaluation for stocks] is driven almost entirely by a handful of Big Tech stocks.
The S&P 500 Equal-Weight Index trades at 18.7 times forward earnings, which is in line with its 10-year average, and the Russell 2000 trades at 32 times forward earnings, below its 10-year average.
This paints today’s stock market in a whole new light. And it underscores a point that we repeat regularly here in the Digest…
It’s not so much a “stock market” as it is a “market of stocks.”
The market is not one huge monolith that rises and falls in unison. It’s made up of thousands of different stocks that perform well and poorly at different times, for different reasons, and in different market environments.
In yesterday’s Digest we highlighted how all three of our expert analysts – Louis Navellier, Eric Fry, and Luke – believe that there are far better stocks for your portfolio here in 2024 than the Mag 7.
In that Digest, we went on to profile the opportunity in small- and mid-cap AI stocks. We also highlighted a string of 30%+ winners that Louis Navellier has locked-in in recent weeks – it’s more evidence that strong returns are possible in a low-ERP/high-CAPE market.
By the way, Louis’ gains are made possible in part thanks to his Quantum Cash system. He’s spent 40 years developing this market approach that helps him find select stocks that are poised to climb regardless of market conditions. You can learn more about his Quantum Cash system by clicking here.
Taking it one step farther, remember that price trumps everything, including bearish indicators
Regular Digest readers know that I skewed bearish in 2023.
So, did that mean anyone reading my Digests missed out on last year’s explosive returns?
I hope not, because my repeated refrain was “mind your stop-losses but trade this market higher for as long as the bullishness is with us.”
At the end of the day, the ERP, CAPE, and every other indicator out there are just background noise if you’re in a surging stock.
Bullish momentum trumps everything.
So, here’s what that means, practically speaking…
Say you’re invested in a Mag 7 stock with a lofty PE, but you don’t want to sell. After all, that Mag 7 stock is still grinding higher.
Well, don’t sell. Continue riding it for as long as it climbs, but you should consider using a tighter stop-loss. Or perhaps you want to sell down part of your position today to lock in some profits and have less exposure to it.
A broad rule of thumb would be “the loftier the valuation, the tighter the leash” whether that’s through your chosen trailing stop-loss or a smaller position size.
But at the end of the day, if a stock is climbing, it’s doing its job for you. So, don’t interrupt it.
Bottom line: Yes, the typical stock doesn’t appear all that attractive today, but that doesn’t have to influence your portfolio.
Focus on the strength/weakness of your specific holdings and the bullish/bearish momentum of each position. Mind your stop losses and be aware of indicators that suggest “danger,” but ride the bullishness as long as it’s making you money.
That way, you can safely ignore bearers of bearish news.
Have a good evening,