Topics: Required Returns, Equity Valuations, Cost of Capital

I was doing some reading on vacation and came across a WSJ article that I disagreed with enough to pause my vacation to write about.

“Stocks Haven’t Looked This Unattractive Since 2007”

Hmm. Interesting.

The ongoing banking crisis, rising interest rates, (potentially entrenched) inflation, falling housing prices, etc, but Equity Risk Premiums are at their lowest levels since 2007? I would have thought that Equity Risk Premiums are higher as a result of all of the risks in the market right now, and there are many...

Welp… I guess there’s only one way to find out if I agree…

*Puts on blue light glasses*

Let’s do some Stonk Science!

An Introduction to the Equity Risk Premium

Equity Risk Premiums (ERPs) are an excess return earned by an investor when they invest in the stock market over a risk-free rate.

Said differently, it’s the extra return investors require for holding risky assets. More risk = more return. The ERP is the specific number that makes this happen.

For more on how the ERP influences stonk valuations, check out this article.

For more on how risk influences required rates of return, including the ERP, check out this article.

If you don’t want to read another article, then here’s the DL:

The higher the perceived risk in the market/economy (volatility of cash flows is how I think about this), the higher the ERP, which leads to a higher required rate of return (discount rate), and thus a lower stonk price (everything else held constant).

Sorry to my hardcore finance fam who wanted a more complex explanation… We’ll get complex and convex soon…

There are several claims this article makes that I want to evaluate:

• The allure of stonks has diminished

• Bonds are offering a “once in a generation opportunity”

• Value stonks are “dirt cheap” relative to growth stonks

Let’s see if we agree with Mr. Eric Wallerstein…

Stonks Aren’t A Good Investment?

Here’s Eric’ specific quote:

“The reward for owning stocks over bonds hasn’t been this slim since before the 2008 financial crisis… The allure of stocks dimmed recently when bond yields shot higher and the corporate-earnings picture continued to darken.”

First off, they’re called “stonks”.

Eric computed the S&P 500’s earnings yield (trailing twelve-month earnings) minus 10-year treasury yields, to calculate an ERP and found that it has hit its lowest level since October 2007.

That’s not great, because it implies that you are purchasing stonks for an expensive valuation relative to the return on risk-free assets. Why would you buy stonks for a theoretical return of 1.6% + 10-year treasury rate when you could wait and buy them for 3%-4% + 10-year treasury rate? Since the computed ERP (hypothetical return on top of the RFR) is so small, you should just buy Treasuries, right?

I would disagree and side with Harvey Dent when he said *clears throat* “the night is darkest just before the dawn. And I promise you, the dawn is coming.” Here’s why:

Eric’s method of computing the ERP, using TTM earnings, is based on historical returns, while stock prices are based on current circumstances and future expectations. Using a historical calculation makes the incremental return for owning a risky stonk extremely low (more on historical measurements of risk here). Using future expectations, there are two methods I (and the market) prefer to use when evaluating stonks:

Kroll (FKA Duffy Duff & Phelps) has a cost of equity calculator (CAPM) and regularly publishes an equity risk premium calculation to support its calculations. They recently increased their ERP to 6.0%, its highest level since 2015.

• The next is from my professional celebrity crush, Aswath Damodaran (the OG valuation guru). He produces country-specific risk premiums and ERPs. Instead of using historical values (Earnings-yield method), he computes a forward-looking ERP using current market pricing (as specified in this article).

  For those who don’t want to read through it all, here’s a summary: he creates a two-stage dividend discount model using a 5-year forecast of expected dividends and buybacks from analyst estimates and a terminal growth rate equal to the RFR. He then solves for the expected rate of return on stonks and subtracts by the RFR to compute an implied equity risk premium. See below for an example for 2018:

Here’s a chart summarizing the earnings yield method vs. Damodaran’s implied ERP method:

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I find it fascinating that the two ERPs have been diverging as of late. Here’s how to interpret this divergence: stonk prices are high relative to TTM earnings (i.e. you get less in cash flow per dollar invested / you are buying at a lower discount rate / you get less bang for your buck), but are lower relative to projected earnings (i.e. stonk prices are lower based on the future cash flows they will generate / you are buying at a higher discount rate applied to future cash flows / you get more future bang for your buck).

So then it’s a question of what matters to you - past earnings or future earnings?

“Well, what do you think, Drake?”

Here’s a hint: I never develop valuations based on historical cash flows.

Also, I’d never be cool with an expected negative ERP (and neither would the market), but the S&P 500 still appreciated significantly from the late 70’s to the early 2000’s despite having a negative Earnings Yield-based ERP. Long-duration treasury bonds did have monster years following that period, but lower forecasted returns for riskier assets intuitively doesn’t make sense (or dollars).

The article also mentions the S&P 500 CAPE ratio, which is still historically high:

Instead of including a micro TED talk here, I’m going to leave you this article to ponder.

Okay, so I disagree with point 1, but it’s really a matter of how you calculate the ERP and whether you believe valuations are mean-reverting over the LT. Even when asking asset managers and investment professionals about the correct ERP to use, they are all over the place (summarized on p. 15 of this Morgan Stanley report).

At the end of the day, it’s about what you believe future cash flows will be and how much you’re willing to pay for them.

Bonds Are The New Toilet Paper

“Bonds are offering a ‘once in a generation opportunity, but not once in a lifetime,’ said Tony DeSpirito, BlackRock Inc.’s chief investment officer of U.S. fundamental equities.”

I’m immediately skeptical anytime someone calls an investment a “once in a generation opportunity”, as I’ve seen that line too many times on the Motley Fool (sorry). Tony is no joke though, so why is he promoting bonds so hard, he’s not even a fixed-income manager (he’s a Fundamental Equities manager).

Tony says that “the consensus view is that bonds now offer the best opportunity to invest at attractive prices since the global financial crisis.”

Let’s check out Treasury YTMs to see why:

To paraphrase Ron Burgundy… Well those YTMs escalated quickly. It makes sense why he says that bond yields are “the most attractive (they’ve) been in over a decade”.

In that same article, instead of encouraging investors to purchase bonds, he goes on to outline why stonks are likely a stronger investment over the long term by using ERPs.

Based on his S&P 500 ERP calculation, which is computed using the earnings-yield method, he believes that his computed 1.71% ERP is above the long-term average of 1.62% for the index, making stock pricing relative to bonds “slightly better than historical averages”. This additional risk has helped stonks outperform bonds over long holding periods (chart below):

Think the point here is pretty straightforward: If you want to enter into bonds, now is a good time to lock in solid yields, but stonks still generate higher returns over the long term. Talk to a financial professional if you need help building a financial plan or need help constructing a portfolio (you can slide into my DMs if you are completely lost here).

Return of The Value Stonk?

I remember my early days of college reading The Intelligent Investor and learning all about value-investing with my fellow financiers… we thought we were really cool talking about stonks with low P/E and P/B ratios. We had arrived. But, once we found out that value stonks had underperformed growth stonks, we descended into the depths of despair… We were, in a word, heartbroken. Was Ben Graham wrong?

When Eric says that value stonks are “dirt cheap”, I am very inclined to believe him, as it justifies all the times I’ve ever underperformed the market. Yes, I’m absolutely biased, but other research also points to this.

Cliff Asness of AQR, for example, computes a value spread based on the valuations of growth stonks relative to value stonks. He found that value spreads are at their highest levels since the 2000 tech bubble. In one of his updates on value spreads, he asks a big question: “Is everyone out there cray-cray?” No, Cliff, I hear you.

From my perspective, there are several key reasons why value stonk returns have looked like a full-blown dumpster fire as of late:

• Technology stonks (which make up a large portion of the growth stonk portfolio) thrive in low-interest rate environments when capital is cheap; it allows them to invest, grow, and develop extremely fast. This extends the duration of their cash flows and thus results in price appreciation.

• Energy stonks make up a large portion of the value stonk universe and, despite their prices rebounding as of late, they are trading at extremely low valuations (based on historical cash flows) due to ESG restrictions and extremely volatile energy prices (that are expected to decrease).

  

• Financials are another large constituent of the value stonk portfolio and, well, the recent banking crisis hasn’t exactly helped their valuations.

Conclusion

• Are stonks the most unattractive they’ve been since 2007? I’d argue no.

• Equity Risk Premiums based on forward-looking, market-based estimates have been increasing and have resulted in lower valuations.

• Bonds have high YTMs based on historical yields, but stonks still typically outperform them over the long term. I rather enjoy trading the yield curve, but most people should make the stonk/bond decision based on their personal financial goals.

• Value stonks are cheap relative to growth stonks, but it’s because they went through a bit of a rough patch. It may be worth giving them a chance, they might surprise you…

Thanks for reading. LiKe AnD sUbScRiBe FoR mOrE! I’m going back to vacationing… Have a Good Friday!