Absolutely relative

15-04-17 10:00 | Markets and investments | Fredrik Wilander

Stock markets keep on rising, spurred by very loose global monetary policy. Equity valuations, as measured by price to realized or expected earnings (or dividends, book value or equivalently) look stretched by historical standards. Are investors overpaying for stocks, becoming irrationally exuberant and/or start to ignore the risks with equity investing?

One of the fundamental assumptions of finance is that investors are risk averse. In the sub-field Asset Pricing, it then follows that investors should require a return premium for investing in risky and uncertain cash-flows. Put it another way, for any given expected cash flow stream, the riskier it is (volatile, lower in bad states of the world, uncertain that it will materialize at all), the lower should the price investors are willing to pay for this stream be compared to a safe/certain cash flow stream of similar magnitude.

Do investors still require a risk premium?

So, let’s try to dig a bit deeper into this risk premium. We cannot observe it directly, as we do not know investor expectations on future cash flows. But we can get some sense of whether it is large or small by comparing the pricing of risky vs. safe cash flows. In the two graphs below we compare the earnings yield on broad equity markets (the expected market earnings in the coming 12 months divided by the market value) to the yield on safe government bonds for the U.S. and Japan respectively. This a very crude estimate of how investors price riskier vs. safer cash flows, but we get some sense on if they require a risk premium to hold equities or not. If they do that, we would expect the blue line to be above the red line. And we see that this is typically, although not always, the case. In Japan in the late 80s and early 90s it was not the case. And during the peak of the dot-com frenzy in the U.S., it was also not the case. Both these episodes many probably today characterize as stock market bubbles.

We can also read from the graphs that today this crude “implied” measure of a market risk premium is not only positive, but also by historical standards very large. For Japan, it has hardly ever been bigger. Now, rightly this is partly because government bond yields are so low. But it nontheless means that investors require compensation to take on equity market risk.

Interestingly, in Emerging Markets, where the rise in equity prices have been weaker over the past years, and where absolute valuations are lower than in the US or Japan, that is also where we find situations similar to the 1990s Japan or the dot-com peak in the U.S. At the time of writing the expected earnings yield on the Brazilian Bovespa index is almost 12%. Cheap many would say. But Brazilian 10-year yields on Real-denominated GBs is almost 13%. So given that I get the currency exposure anyway, should I buy the bond or the equity market? Just because something has gone up (like Japanese or US equities) doesn’t necessarily make it expensive and just because something has fallen in value doesn’t make it cheap.

Finally, returning to the big gap between equity and bond pricing in developed markets – this is obviously no guarantee for neither absence of equity market corrections, nor many years of strong equity returns. But in my mind it does not look like markets or investors are irrational and have forgotten about the risks to equity investing.

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