This crucial measure signals that stocks are nearing ‘buy’ territory
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Peter Kraus spent decades at Goldman Sachs, helped pilot Merrill Lynch through the financial crisis, and for over seven years headed asset management colossus AllianceBernstein. Now, as CEO of newly launched Aperture Investments, he’s living through the coronavirus crash, his sixth financial crisis. In times of extreme turbulence, Kraus turns to what he considers the most reliable guide to pinpointing when stock prices shift from frothy to cheap. It’s a wonkish-sounding yardstick called the “equity risk premium,” or ERP.
“Determining the new ERP caused by fear in the market gives you the best point estimate for where people should say, ‘The market is cheap,’” Kraus told Fortune. He adds that with coronavirus fears prompting the 12% fall in the S&P on “Mad Monday” (a.k.a. March 16), “we’re almost there.”
The equity risk premium has been called the holy grail of investing by academic economists––and it’s the lodestar for Kraus as well. It’s simply the difference between the expected return on stocks and the what investors can garner holding supersafe U.S. treasuries. The ERP is the cushion required to compensate shareholders for the rough ride of owning equities—for weathering the wild, unforeseeable swings that can wipe out years of gains in a matter of weeks. A Rob Arnott of Research Affiliates notes, it could be renamed “the equity fear premium.”
As Kraus points out, the ERP is a volatile number. It’s low in times of economic calm and stability, and it spikes when investors view danger ahead. When the ERP jumps, investors are signaling that they’ve suddenly awakened to a much more fitful, unpredictable world. Hence, they demand extra juice from equities, because looming strife in the economy threatens to hammer what looked like a steady, strong parade of earnings.
That extra margin for safety can come only from one reaction: a drop in equity prices that raises the dividend yield, increases the number of shares companies can purchase with each $1 million in buybacks, and hence, boosts what folks can pocket in the future once the storm passes.
Kraus reckons that over the past several decades, the ERP has averaged around 3%. But, he adds, it fell far too low during the recent boom. “Over the last nine months, the market was too comfortable and complacent, and too expensive, showing low volatility for a long period,” he says. “That made me very nervous.” He adds that prices kept soaring while earnings rose only slightly, causing price/earnings ratios to expand, so that what investors could expect from stocks kept shrinking. “As a result, the ERP kept coming down,” he says. “That was a sign that the markets were fragile.”
The shift from exhilaration to near terror has swelled the ERP, says Kraus, and that explains much of the S&P 500’s 30% drop since mid-February. “The ERP by my calculation is now around 6%,” he explains, twice the historical average. Kraus uses that 6% estimate as a building block to determine when prices look reasonable, based on the jump in the fear factor the ERP reflects. The 10-year Treasury yield has recently careened to all-time lows of below 1%, but Kraus chooses that as a good bet on where the number will settle.
Here’s how Kraus does the math. The new, fatter, total return investors now expect from equities consists of the 6% risk premium plus the 1% projected yield on the 10-year, for a total of 7%. Given that, the market’s P/E ratio should be 14.3. That sure would promise a much more lucrative future for shareholders than the P/E of 24, and 4.2% return it posits, that reigned just a month ago.
Kraus forecasts that S&P earnings per share will drop 25% in each of the next two quarters compared with the year-ago periods. But he foresees a rebound to $160 per share in 2021, 14% above the level for 2019. Earnings of $160 and a multiple of 14 would put the S&P at 2240. At the close on March 16, the index registered 2386, just 6.5% above that level. Kraus predicts that only a slight decline would turn stocks into a bargain based on the future returns of 6 points over Treasuries that today’s gun-shy investors demand.
Kraus concludes that pessimism is too rampant, and as a result, at 2240, stocks would be even cheaper than investors reckon. He says that in 2008, the ERP jumped to 9%, and investors who bought then booked the best returns of the past half-century. Today’s 6-point ERP, he believes, will shrink as confidence returns, boosting multiples well above his estimate of 14.3 as the most likely benchmark. “The economic effect of this crisis is likely to be much more short-lived than the Great Recession,” he says. “My estimate is around six months to nine months.” If the ERP then returns to 3%, shareholders would see prices above the February peak.
This writer agrees with Kraus’s view that the ERP has jumped, and finds 6%, using his methodology, to be a good estimate. As Kraus says, it’s a good bet that as the hurricane passes, the ERP shrinks. The big issue will be earnings. The 2019 numbers were an all-time high, and that suggested a profits bubble. It might take a terrific economy to hoist them 14% higher a year from now, and if that doesn’t happen, it will be tough for markets to regain anywhere near their early-2020 highs. But Kraus’s rigorous analysis points to a plausible outcome. It’s good to hear reassuring words from a veteran who’s seen it all.
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