The Equity Risk Premium
There is a tendency among investment types to get lost in jargon and complexities that sound like brilliance but are meant to impress, not illuminate. There is also a tendency to focus on relatively short-term market trends. While the following is applicable to all long-term investors (especially Mangham clients), in my mind’s eye, my audience for this letter are my sons, whose lives will be, hopefully, sufficiently long to take advantage of whatever wisdom I can impart, and who are not impressed by my jargon or intellectual flash. To this end, I hope you enjoy what I am writing and find it helpful – it comes from the heart and is not guaranteed to be right, but sincere in my best effort to use experience to discern a path forward.
What is going to happen to the S&P 500 in the years ahead? As a self-taught student of history, I’m convinced that different generations can have vastly different experiences depending on the political and economic events of their time. We tend to generalize about how stocks behave, for example, using data that extends back for about 100 years. Over this period, stocks returned about 6.5% per year after inflation. Can we expect the same in the future? It certainly appears that we have entered a new generation-long transition with bond yields rising consistently for the first time in over 40 years. Other cultural shifts are occurring as well. Unfettered globalization has revealed its limitations such as overreliance on mercurial autocracies for critical imports and an excessive financialization of the US economy with its attendant deindustrialization and acceleration of inequity. Not to mention that sea levels will likely be over two meters higher during the lifetime of our youngest generation. Yes, the experience of the next generation will be very different from our own. Don’t buy a beach house.
So, shall we continue to own the S&P 500? I was drawn to a recent article in The Economist (“What a Key Valuation Measure Says About Buying the Dip;” June 25, 2022) which focused on a measure called the equity risk premium. With government bonds available that provide a yield that is essentially guaranteed (“risk free”), investors buy stocks only when the prospective yield on the stocks is sufficiently high as to balance the higher risk. As of June 30, 2022, 10-year Treasuries yielded 3%. A measure of the expected yield on a stock is the earnings yield, or simply earnings per share divided by the share price. That number is about 3.5% (calculated using the average earnings of S&P 500 companies for the past two years ending June 30, 2022). Unlike bonds, investors also expect earnings yield to grow; for several decades, up until 2009 the real growth rate of earnings (factoring in inflation) was about 3.5%. The equity risk premium is equal to (Equity Yield – Risk Free Yield) + Earnings Growth Rate, or (3.5% - 3.0%) + 3.5% = 4%.
So far, these are simply numbers without context, but a chart shows some interesting trends that, I believe, allow us a window into the future. First, the chart below graphs the equity risk premium as defined above over the past decade or so. The equity risk premium has fluctuated from about 3% to about 8%. It is currently about 4%. I think it is striking that the equity risk premium was fully 8% at the depth of the pandemic (March 2020) and has now dropped to 4%.
Observation 1: In spite of the gloom that has suffused the financial press, investors are not demanding much of an equity premium (i.e., stocks remain expensive).
Observation 2: Stocks remain vulnerable to interest rate rises. Over the next year or so, I think rates will continue to rise and then will stabilize. My best guess is that eventually inflation will stabilize at 3% and bond yields at 4%. It’s a guess, and I may be wrong with my target, but if I’m right with my direction, the short-term risk is that bond yields will rise and/or equity risk premia will rise, and stocks will fall.
Observation 3: Even if my short-term views are wrong, the exercise gives some perspective on long-term return expectations. If bonds are providing a yield that is just equal to inflation, then stocks will likely deliver a real return equal to the equity risk premium, and no more. It will be hard to gain the 6.5% real return that was the norm of the previous century. However, take some solace knowing that stocks are still better than bonds!
Observation 4: This stems from a deeper look into historical earnings growth rates. The below chart of real earnings growth of the S&P 500, averaged over rolling five-year periods to smooth out the fluctuations, shows a marked consistency up until about 2001, when real earnings exploded. The result was a real earnings growth rate measured over the last two decades of nearly 20% per year. The likely causes were aggressive Fed easing, very low interest rates, offshoring of our industries, persistent wage stagnation, gains due to technological advances, and (relatedly) the remarkable profitability and growth of the Internet giants. Regardless of the exact mixture of these causes, these are all one-off events that reach natural limits and are unlikely to recur. I think a reasonable conclusion is that the more modest 3.5% earnings growth rate of the past is likely to be the norm for the future – I don’t see a repeat of the boom years of 2000-2020 for the S&P 500.
I’m sorry, son. It would be nice to be proven wrong, but don’t expect the S&P 500 to bail you out. Better to get a good job.
On the other hand, remember that the S&P 500 is not the entire market. There are some very reasonably priced “value” stocks overseas with high equity risk premia. Make sure you have some of these. Also, innovation is alive and well in our country and, I believe, is accessible through private investments. Stay exposed to private equity managers with robust records if you can.
Joel Mangham and the Mangham Associates Team
About the Author. Joel Mangham founded Mangham Associates in 1991, with prior experience at Cambridge Associates and Gemini Consulting. As Founder, Joel has guided the team toward building and maintaining a culture of excellence and integrity; putting clients’ needs first in a collaborative and collegial environment. Joel is an avid hiker and rock-hound, and lives with his wife Michele on their sheep farm in Albemarle County, Virginia.
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