Back then, a double dog challenge was often a child’s first introduction to risk-reward assessment. The rarely featured double dog challenge occurs when one child challenges another to do something silly. Usually, the daring child asks for an incentive to complete the challenge.
When evaluating a Canine Double Challenge, the reward is usually evaluated first. Maybe there are a few candy bars or a soda to complete the challenge. Then comes the risk assessment. Does the potential for breaking an arm or a leg exist? Perhaps worse, at least in the minds of some children, what will be the punishment for being caught? Simply, is the reward enough to properly offset the risks associated with the dog’s double challenge?
Assessing the risks and rewards of a canine double challenge isn’t all that different from investing in stocks, as we explain.
Investors should expect compensation in the form of capital gains and/or dividends/coupons commensurate with the investment risk. To help assess the amount of risk compensation offered by the market, investors need a risk-free return to base the assessment on.
US Treasury securities are a perfect yardstick for this task. They are considered the only risk-free asset in the world. We can debate the merits of their position all day, but regardless of your opinion, it’s a fact on the minds of almost every investor. Additionally, we can easily find returns for investment durations ranging from next week to 30 years to compare our risky assets.
In our article, Goodbye TINA, Hello BAAA, we argued that expected stock returns for the next ten years are about the same as Treasury bond yields. In the current pricing scenario, the premium paid to equity investors for taking risk is zero. Accordingly, the article argues that Bwaves Are Anot Aalternative to stocks.
The chart below from the article shows that five popular methods of calculating expected stock returns range from 4% to -4%. At the same time, yields on risk-free Treasury bills are close to 4%.
Expected stock returns are on par with risk-free Treasury yields, but woefully below the premium spread investors should demand. The simple conclusion is that for the entire next ten years, bonds are the best bet.
Equity risk premium
In addition to the long-term bond analysis presented in our article, there are other ways to assess whether equities offer an acceptable premium to compensate investors for taking on additional risk. One such model and the subject of this article is the equity risk premium.
Equity risk premium, like the three methods we share in the article, is a valuation-based calculation. However, it tends to rely on shorter-term fundamentals. Essentially, our model looks at expected 1-year EPS divided by current price and compares it to an inflation-adjusted 1-year US bond yield.
The higher the equity risk premium, the more compensation equity investors receive for assuming risk.
The chart below plots the risk premium for S&P 500 stocks using trailing and future earnings. Special thanks to Kailash Concepts for providing the stock data for the chart.
According to the graph, are stock investors fairly compensated for owning stocks? We can answer the question in different ways.
One way is to compare the current risk premium to recent pre-pandemic averages. As noted, apart from a few short-term instances, premiums have not been as low as they are today in 20 years. Moreover, these cases similar to today’s occurred after recessions, when the risk of another downturn was minimal and earnings had significant growth potential as the economy recovered. While the premium was lower than average in these cases, earnings and economic prospects were better, perhaps justifying a lower risk premium.
Another way to look at the premium is to assess the risk associated with the current financial and economic environment and compare it to the premium. Today, given the potential market turbulence from a possible recession, higher interest rates, inflation, an aggressively hawkish Fed and the geopolitical situation in Ukraine, we should be paid more, and no less, to take risks. The other consideration: playing it safe in bonds earns us a comfortable 4% risk-free.
Given the riskier than normal outlook and tighter than average risk premia, bonds deserve more attention. BAAA!
How stock premiums can normalize
Three key factors are used to calculate the equity risk premium: earnings, equity prices and risk-free rates.
For the premium to reach a more acceptable level, the numerator must increase and/or the denominator must decrease. In other words, there must be a combination of higher earnings, lower stock prices and falling returns. We could create a complex chart showing the many combinations, but instead it is better to focus on the elephant in the room: recession risk.
If we do enter a recession, profits are likely to fall. The graph below shows that incomes often decline significantly during recessions. If they fall, the equity risk premium will also fall. Therefore, stock prices must also decline to keep the earnings yield stable.
However, the blame does not rest solely on earnings and stock prices. If yields fall significantly, the premium may increase.
The three factors will change. Appreciating what may change and how much, given various economic scenarios, will help you better appreciate how and when the equity risk premium may normalize.
The model shown above is for the S&P 500. Each stock has its own risk premium. While we don’t believe the market is paying us right, many stocks and some sectors have potential earnings growth rates well above market levels with potentially lower earnings volatility during a recession.
Portfolio management involves holding assets in stocks and bonds. We believe in active management in which allocations to stocks and bonds change as their risk-return calculus changes. Lower risk premiums in a risky environment are now leading us to reduce equity risk.
“There is no analog. Today’s starting points are unlike any other we’ve seen. The greatest risk is to extrapolate into the future from a comfortable past, confirmed by recent data. Imbalance is the new balance. Erik Peter One River Asset Management
The economic, financial and geopolitical risks are excessive! Shouldn’t the equity risk premium reflect the situation?
If we challenge you to buy stocks, you should ask for a return that compensates for the added risk in the current market environment.
The author or his company may have positions in the titles mentioned at the time of publication. Any opinions expressed herein are solely those of the author and in no way represent the views or opinions of any other person or entity.