Investing in stocks involves more risk than investing in bonds, and as a result, the potential reward should be higher. The current yield on a 10-year treasury notes (still considered a risk-free investment despite recent downgrades) is about 4%. The current earnings yield on the S&P 500 is about 4.5%. This yield is based on trailing S&P earnings and is calculated by dividing S&P 500 earnings over the index value, which is the reciprocal of the more commonly referenced Price to Earnings Ratio (P/E Ratio). The difference between the two yields is the equity-risk premium, i.e., what you are paid for taking extra risk.
The current equity-risk premium of less than 1% is the lowest in the last 15 years and compares unfavorably to the 3% median, which brings the question of whether we can get back to a 3% value over the next year, or more. Before going further, it should be noted that, historically, low premiums have not signaled the end of a stock market rally. There are 3 components in the calculation, the yield on the 10-year treasury, the value of the S&P index and the earnings of the S&P index.
Bond yields would have to fall to increase the equity-risk premium. While the Federal Reserve (Fed) is near the end of its rate hike schedule (the likelihood of another hike this year is currently about 25%), we think there is even less chance the Fed will cut rates this year. And if they did, it would affect the short-end of the curve more than the 10-year rates. So, an equity-risk premium increase over the next year is not likely to be driven by the bond market. Perhaps in the longer term, rates will fall.
This leaves the index value and earnings as the drivers of an increased equity-risk premium. The value would need to fall, or the earnings would need to rise. The happier scenario is obviously rising earnings. Earnings are estimated to be flat in 2023 compared to 2022 but rise in the low double digits in 2024. This provides breathing room for both the index to rise (i.e., the stock market to go up) and the earnings yield to increase. It’s a result of earnings growing faster than the index value. The total return would include both the index price appreciation and the dividends paid.
Can we get back to a 3% equity-risk premium within 12 months? Probably not without a bear market. If the market increases, we can recover to a 5% earnings yield with decent earnings growth. However, without interest rates falling, it will be tough for the equity-risk premium to grow much above 1%. However, over the next 4 years, it can expand through continued earnings growth and slightly slower index price appreciation, and perhaps rates falling. This would increase the earnings yield enough that the market would get the premium closer to its 3% historical median while still generating positive stock returns.
This analysis drives home a couple of points. The first is that currently investors are not receiving much of a risk premium on their stocks. The second is that over the next four years, most stock returns are going to be driven by earnings growth. Any company in which Eagle Ridge invests, we make sure we have confidence in the earnings growth potential, and that is more important than ever.