In our annual economic Investment Outlook, we predicted that interest rates would rise but not enough to derail the expansion. At the same time, we anticipated that the conflicting signals of robust earnings growth and above-average valuation would settle somewhere in the middle. In other words, stock prices would rise (albeit in a choppy fashion) but valuation would fall. Although the story isn’t over, these forecasts are evolving nicely as we approach the midpoint of the year.
Despite a substantial rise in interest rates and rising equity markets, stocks are even cheaper compared to bonds than they were to start the year. When evaluating the relative attractiveness of stocks versus bonds, investment managers commonly look at what is termed the “equity risk premium.” Because stocks are riskier investments than bonds, investors generally require more earnings per dollar invested in stocks than they do interest for every dollar invested in bonds. The equity risk premium is measured by comparing stock earnings relative to prices, called the earnings yield (the inverse of the P/E ratio), and the yield on a benchmark bond such as the U.S. 10-year Treasury. The spread (or earnings yield less bond yield) is termed the equity risk premium.
As we began 2018, the S&P 500 forward earnings yield was 5.4 percent, earnings were expected to be roughly $146 and the index price was 2,673. At the same time, the 10-year Treasury was yielding 2.4 percent. As such, the equity risk premium was 3 percent. Nearly five months later, after more volatility than we’ve experienced in recent years, earnings are expected to reach $167 in the next twelve months, an astounding 14 percent above January expectations. With the index price up to around 2,700, the earnings yield sits at 6.2 percent. Prices have risen but earnings expectations have risen by a larger amount. Thus, stocks have become less expensive.
The Fed, continuing its path to normalizing policy rates, higher inflation expectations and a greater supply of Treasury bonds, have all contributed to a bounce in interest rates. The 10-year Treasury just eclipsed the 3.1 percent level, its highest since 2011. As rates move up, bond prices move down and investors have lost approximately 3.0 percent in bond portfolios this year. As you would expect, lower bond prices and higher yields mean that bonds have become less expensive.
Finally, comparing the current earnings yield and Treasury yield, we have an equity risk premium of 3.1 percent. While we continue to prefer stocks over bonds in the near term, our belief is we are late in the economic expansion and, as such, continue to recommend a neutral allocation to equities and only a slight underweight to fixed income securities.
Takeaways for the Week:
Thus far, market behavior has been consistent with our Investment Outlook
Increasing earnings expectations have overcome lower valuations