In light of the fact that the S&P 500 reached new record highs last week, this note re-visits the issue of United States equity market valuations. As will be shown, although low interest rates are offering some support to equity market valuations, the market still appears expensive once allowance is also made for an apparent rise in the equity risk premium.
Market Breaks Resistance
Stocks Appear “Cheap” Given Low Interest Rates, but looks can be deceiving
But the Risk Premium Also Appears to have Increased
So while some might argue equity market valuations are relatively cheap given the decline in bond yields, an equally valid argument is that this persistent apparent cheapness of equities must reflect a rise in the equity risk premium – potentially due to population ageing, the shock of the global financial crisis, or simply a refusal to accept bond yields will stay very low for an extended period. Either way, investors appear to be demanding a higher equity risk premium relative to bonds.
So what’s Fair Value?
While the EBYG has tended to drift up over recent decades, it has tended to trade in a 4 to 7% range since the financial crisis, with an average rate of around 4.5%. If we assume a fair-value EBYG of 4.5% and a normalised 10-year bond yield of 2.5% (i.e. a rate which may hold over the next few years due to weak growth and low inflation), then a fair-value forward PE ratio is still around 14.3, or very close to the 14.6 average since 2003.
All up, allowing for both low bond yields and an apparent increase in the equity risk-premium, a fair-value forward PE ratio for the S&P 500 would still be not far from the 14.5 level it has averaged since 2003. Given the forward PE ratio is currently 17.3, that suggests the market is still richly priced.
Wall Street at Risk of Correction
With US economic data travelling well, and the Federal Reserve sidelined, chances are that Wall Street may continue to test the upside for some time further. A relatively benign earnings reporting season (as is typical given expectations are lowered ahead of time), may be another supportive factor.
That said, with valuations still seemingly stretched, the risk of an eventual serious pull-back is building. With this in mind, investors seeking to profit from, or protect against, a declining U.S. share market could consider the BetaShares U.S. Equities Strong Bear Hedge Fund – Currency Hedged (BBUS). BBUS seeks to generate magnified returns that are negatively correlated to the returns of the U.S. share market (as measured by the S&P 500 Index), hedged to Australian dollars.
Please note: The Funds’ strategies of seeking returns that are negatively correlated to market returns is the opposite of most managed funds. Also, gearing magnifies gains and losses and may not be a suitable strategy for all investors. Investors in geared strategies should be willing to accept higher levels of investment volatility and potentially large moves (both up and down) in the value of their investment. Geared investments involve significantly higher risk than non-geared investments. Investors should seek professional financial advice before investing, and monitor their investment actively. An investment in any of the Funds should only be considered as a component of an investor’s overall portfolio. The Funds do not track a published benchmark.