Stock market bulls can find reassurance in the equity risk premium, which suggests stocks are valued fairly or slightly expensive. In contrast, bears may find confirmation in other standard valuation ratios – such as market capitalization-to-GDP, Tobin’s Q, the CAPE ratio and market cap-to-corporate profits – that suggest stock prices are substantially overvalued.
Who is right? And what variables matter most in assessing the risk of major shocks in broad equity markets?
By simply looking at the Gordon Growth Model, we can see that equity prices are sensitive to the equity risk premium (the real equity yield minus the real bond yield) as well as some definitions of the bond risk premium (e.g., the real bond yield minus real GDP growth) and the equality risk premium (which we define as the difference between real GDP growth and real dividend growth). This decomposition can help illuminate how macro events affect equity prices.
We take a deep dive into these issues in our recent Research piece, “Three Dogs That Did Not Bark: Risk Premia and Stock Market Shocks.”
- Standard valuation ratios indicate a very expensive U.S. stock market, while the equity risk premium suggests that stocks are fair to slightly expensive relative to bonds. However, the equity risk premium is a deceptive measure of equity value.
- For a fuller picture, we believe investors need to look at three risk premia: the equity risk premium, the bond risk premium and the equality risk premium.[i] These premia have shrunk, suggesting frothier equity values, owing to quantitative easing (QE), increased leverage, lower taxes and other factors.
- Yet there is a variety of plausible mean-reversion scenarios in which these metrics start flashing red – among them, quantitative tightening, deleveraging, populism that impedes trade flows and raises some taxes, and a clampdown on tech giants.
- Bubbles, though, can last longer than intuition suggests: Over short periods, bears are likely to be right on the fundamentals but wrong on the market.
When will they bark?
A mean-reversion scenario could set off the three dogs – the equity risk premium, the bond risk premium and the equality risk premium. Indeed, probabilities of large stock market shocks depend critically on whether valuation metrics endure or revert to historical means.
Over a 10-year horizon and under a “fairly valued” regime, where valuations stand firm, our analysis suggests the probability of a 50% sell-off is 59% and that of a 70% sell-off is 57%.[ii]
Under a full mean-reverting regime, our analysis suggests a wholly different story: An earnings yield of -1% results in very large drawdown probabilities over 10 years. A 50% sell-off has a 72% probability, and a 70% sell-off has a 69% probability.
What these simple calculations illustrate is the potential for large surprises at current valuations should these measures revert to historical norms. That could take a long time, if ever, to materialize.
In the meantime, watching the dogs carefully could prove a useful exercise.
For an in-depth discussion of this topic, read our Research article, “Three Dogs That Did Not Bark: Risk Premia and Stock Market Shocks."
Jamil Baz is PIMCO’s head of client solutions and analytics; Josh Davis is global head of client analytics; and Normane Gillmann is a quantitative research analyst.