Weekly Market Update February 24, 2023
Dow Jones Industrial 32,816.99 -2.99%, S&P 500 3,970.05 -2.67%,
Nasdaq 11,394.94 -3.33%, US Ten Year 3.95%, West Texas Intermediate $76.54
The new year’s six-week stock market rally continues to unravel, the Dow Jones ending lower for the fourth consecutive week and the S&P 500 and NASDAQ down three weeks in a row. Regular readers of this Update may recall my caution against getting too optimistic about the stock market rallies we experienced since the market high ending 2021, as each subsequent rally ended in a lower high.
But it did appear in early 2023 that this rally might end the sequence of lower highs, stimulating the bulls to power the market higher, above the downward-sloping trendline. Sadly, this does not look like it will continue, as stocks have returned to the trendline.
The culprits are no surprise; continued upward pressure on interest rates from the Federal Reserve, and disappointing company results. Fourth quarter earnings reports are almost complete, and the results have been below expectations. If that continues through the end of March, it will mark the first quarter of lower earnings since the third quarter of 2020.
To look at stocks from a more objective viewpoint, let us consider the Equity Risk Premium, or "ERP." It is the additional returns stock investors demand to compensate for the additional risk posed by stocks over government securities. It is calculated by subtracting the yield of 10-year Treasury from the forward 12-month S&P 500 earnings yield, the earning yield merely being the inverse of the price-earnings ratio. It is a simple calculation:
Equity Risk Premium = Expected Market Return – Risk Free Rate
The standard proxy for the risk-free rate is the inflation-adjusted ten-year US Treasury note yield, which now stands at 1.5%, which is the current nominal rate of 4.0% minus the 2.5% forward ten-year inflation rate estimate from the Philadelphia Fed. This is supported by the current yield on the ten-year Treasury Inflation-Protected security (TIPS) security. The consensus twelve-month forward earnings estimate for the S&P 500 is $222.89, and with the index at 3,950 at this writing, the earnings yield is 5.64% (222.89/3,950). So, the ERP is:
5.64% – 1.5% = 4.14%
The chart below shows the ERP at the lowest level since the financial crisis. The modest risk premium currently demanded by investors indicates that stocks are quite expensive, odd given stock’s mediocre earnings in a rising interest rate environment fueled by a Fed determined to get inflation down to its 2% target. What does this mean for stocks?
“The equity risk premium illustrates the apparent divergence of investor expectations from economic reality that plays a role in forming our wary outlook for stock markets. Attractive risk/reward buying opportunities are typically seen at surges in the equity risk premium demanded by investors, as the accompanying chart depicts.The equity premium can be restored to more typical levels seen for the last 20 [years] by either 1) a sharp increase in corporate earnings 2) a sharp decline in Treasury yields, or 3) a sharp decline in stock prices. Which seems like the path of least resistance?” Jonathan Baird, CFA, Global Investment Letter
At present I would go with option 3). Hopes for a slowdown in the pace of Fed rate hikes are not supported by the futures market, where the probability of a50 basis point rate hike at the next Fed meeting is increasing, so option 2) is unlikely. Meanwhile S&P 500 earnings beats are at a fifteen-year low, and companies are reducing their forward guidance, so option 1) is unlikely. After all, with a 5% guaranteed yield from one-year treasuries, why put all your moneyon stocks?
Wishing You a Wonderful Weekend,