Stocks and bonds today send signals that can be difficult for investors to parse. Equities, especially in the US, are richly priced and suggest confidence in the economic expansion. But bonds are priced as if a recession lies ahead even after the late 2016 interest rate increases. Which is right?
We believe the bond market is wrong – that rates are still below fair value after normalizing heading into 2017. This mispricing reflects a mix of factors, including heightened investor risk aversion since the 2007-08 financial crisis and ultra accommodative monetary policy. Recent jumps in bond yields are a partial reversal of these trends. But if bonds have been wrong, can stocks be "right" at such lofty valuations? And can investors justify committing capital at this stage of the investment cycle?
To answer those questions, we think some perspective on equity valuations is in order. For starters, viewing the topic in the context of today's low interest rates may be helpful. Price-to earnings ratios are elevated by conventional metrics, but they turn out to be close to the long-term historical average for periods of low interest rates (Exhibit 1).
Source: Bloomberg, Goldman Sachs Global Investment Research, and GSAM, reflecting the forward price-to-earnings ratio of the S&P 500 Index and US 10-Year Treasury Yields over the period January 1976-December 2016. Past performance does not guarantee future results, which may vary.
We think this historical matching of low rates and high valuations makes intuitive sense: lower payouts from bonds decrease the relative attraction of fixed income and make equity risk relatively more attractive. Looking ahead, in addition to low yields, fixed income investors may face the possibility of flat or negative returns given market expectations for a more inflationary macro environment.
Some view the state of equity valuations today as too elevated to commit capital. We certainly see a high probability of market volatility and short-term drawdowns, which may be difficult to stomach. But we would note that long-term investment returns in environments such as today's historically have been positive, albeit low, and often in the mid-single digits – which we think builds a case for selective, risk-aware exposure.1
Investors themselves appear to expect precisely such a scenario of low but positive long-term returns. This, at least, is what we would infer from the metric known as the equity risk premium (ERP), which reflects the implied extra compensation equity investors demand at a given time to own stocks instead of bonds. This metric can be compared to the subsequent 2-year returns in the S&P 500 Index for a sense of how prescient these views have been over time.
Source: Bloomberg, Aswath Damodaran, and GSAM, reflecting the equity risk premium of the S&P 500 Index versus US 10-Year Treasury bonds over the period January 2000-December 2016, the earliest common data available. This analysis does not represent any GSAM product. Past performance does not guarantee future results, which may vary.
A comparison of ERP and subsequent 2-year S&P 500 Index returns shows that levels seen over the last year have corresponded to mid-single digit subsequent equity market returns in most cases (Exhibit 2) – not stellar, but positive enough in our view for investors to remain generally constructive on equities.
By contrast, the run-up to the both the burst of the Dot-com bubble and the financial crisis of 2007-08 saw lower equity risk premiums in the range of 2-5%.
The ERP today stands right on the cusp of this more problematic territory, having darted past its far edge in the month following the US election. But the ERP is yet to shift decisively into what we would consider a danger zone – a situation which we think calls for a risk-aware yet still constructive approach to equities.
In the eighth year of a slow-growth economic expansion and in a climate of low interest rates, we find it notable that today’s investors appear to demand even average compensation (as measured by the ERP) to own stocks instead of bonds. The question is why?
First, we think investors today are looking through the current environment of exceptionally low interest rates. They view the present central-bank-fueled market environment as a temporary aberration, not some new phase of secular stagnation or permanently low interest rates.
Second, we think a climate of risk aversion has kept investors from driving up equities toward territory that may be genuinely concerning. This climate of risk aversion reflects the fact that the losses of the financial crisis period remain a potent dampener of investor risk appetite. They also reflect pressures on bond yields such as many years of robust Chinese and Japanese Treasury bond purchases, and the quest for yield by both institutional and individual investors.
We believe that equity markets today reflect a climate of low interest rates, and presage modest future growth. Both conditions support our view that equities could deliver modest but still positive returns in the coming years.