Risky Business - Calculating the US Equity Risk Premium

Geopolitical concerns, delays to the Trump Administration’s planned fiscal stimulus, and benign US economic and inflation data have made bond markets more relaxed and equity markets more volatile. The US 10-year Treasury bond yield has rallied from a recent peak of just over 2.6% in March to about 2.2% now. The 12-month forward PE ratio for the S&P 500 index is high in absolute terms at 17.4 times, prompting concerns that an end-of-cycle equity correction could happen at any point.

A high forward PE ratio in isolation conveys some information but not as much as when the risk-free rate is incorporated into the valuation measure, recognizing that low bond yields help sustain high equity valuations. That is where an estimate of the Equity Risk Premium (ERP) comes in handy. The ERP is the premium that equity investors require to compensate them for taking on the higher risks inherent in equities compared to bonds.

The ERP can be calculated by converting the 12-month forward PE ratio into an Earnings Yield and subtracting the risk-free rate (assumed to be the 10-year Treasury bond yield). For the US S&P 500 index the forward Earnings Yield is 5.7% (100/PER) and the risk-free rate is 2.2%. The 3.5% difference is the ERP.

The ERP is therefore a good method of valuing the equity market in a way that takes into account the prevailing level of interest rates. Historically, when the ERP drops below 2%, as was the case on the eve of the GFC in 2007, it is a sign that equity valuations are overcooked relative to bonds and that a bear market is imminent (see first chart).

At 3.5%, the current ERP is consistent with a fairly fully valued equity market rather than a dangerously overvalued one. An ERP in the 2% to 3% range could be considered as flashing an amber signal; under 2% a red danger signal. The other end-of-cycle danger sign we are watching out for is an inverted yield curve. But, with US 10-year Treasury bonds currently yielding 1 percentage point more than 2-year bonds, the yield curve is still positively sloped.

Sources: Bloomberg & Mason Stevens

The next major influence for the share market should be the first quarter profit reporting season already underway in the US. According to FactSet, the consensus forecast for S&P 500 earnings growth in Q1 2017 is 9.2% over the same quarter a year ago. If achieved, it would mark the highest year-on-year earnings growth for the index since Q4 2011 (when it was 11.6%).

Small upgrades have been occurring, mainly due to the Financials sector. There have already been upside earnings surprises reported by JPMorgan Chase (US$1.65 vs. US$1.51), Citigroup (US$1.35 vs. US$1.23) and Wells Fargo (US$1.00 vs. US$0.96). (Goldman Sachs was an exception due to a poor trading result.) Consequently, the blended earnings growth rate for the Financials sector increased to 16.4% from 14.6% at the end of March. The Financials sector is expected to report the biggest year-on-year percentage increase in earnings in Q1 (see second chart). The Materials sector has also seen some earnings upgrades (to 13.2% expected growth from 10.8% at the end of March).

Five sectors have recorded a decrease in expected earnings growth since the end of March due to downward revisions to estimates and downside earnings surprises, led by Telecom Services (to -3.6% from -2.9%) and Utilities (to 2.3% from 2.9%).

Note that a growth rate is not being calculated for the Energy sector because the sector reported a loss in the year-ago quarter. On a dollar-level basis, the Energy sector is projected to report earnings of US$7.5 billion in Q1 2017, compared to a loss of -US$1.5 billion in Q1 2016. Due to this projected US$9.0 billion turnaround in earnings, the Energy sector is expected to be the largest contributor to earnings growth for the S&P 500 as a whole. If Energy was excluded, the blended earnings growth rate for the remaining ten sectors would fall to 5.5% from 9.2%.

Equity market corrections are normal, particularly after a long period of abnormally low volatility as occurred in recent months. But, barring a geopolitical calamity, the fundamentals of earnings growth, interest rates and valuation should continue to be the main drivers of equity markets.