What Changed?
Posted on September 28, 2023 in Stock Market
The S&P 500 is down 5.4% since September 14. That’s a big move in a short period of time. The selloff began a few days prior to the Fed’s decision on interest rates, which was revealed on September 20. However, the selling gained steam following Chairman Powell’s press conference and has yet to relent. Clearly, there was something in the Chairman’s rhetoric that spooked stock investors. Up until that press conference, stocks had defied the sharp upward move in interest rates. In fact, the S&P 500 had risen nearly 10% from April 6, which was the date the 10-year Treasury yield bottomed out this year at about 3.30%, through September 14 (the beginning of the 5% correction). The yield on the 10-year is now 4.55%, nearly a 16-year high and a whopping 125 basis points above that April low.
Maybe the question should be how stocks rose so much in the face of rising interest rates rather than why that trend broke in just the past couple of weeks. After all, low interest rates were a primary justification for high stock valuations for a very long time while the Fed kept interest rates artificially suppressed. One valuation technique that takes into consideration the level of interest rates is the equity risk premium, or the ERP. The ERP is a measure of the added return over the risk-free rate (yield on Treasury bonds) that investors require as compensation for investing in stocks. To arrive at the market ERP, we can simply subtract the yield on the 10-year Treasury note from the S&P 500’s earnings yield, which is simply the inverse of the price-to-earnings (P/E) multiple. The chart below shows the estimates of ERP in green, with the blue line representing the earnings yield on the S&P 500 and the orange line representing the risk-free rate (yield on the 10-year Treasury). You will see that the current ERP of 1.0% is the lowest it’s been in the past 20 years and well below the average of 3.6% over that period. This means that at the S&P 500’s current level, investors are only demanding a very small return premium to the current risk-free rate of 4.55%.
As with any valuation model, there are inherent problems with the ERP. The most obvious is probably that almost nobody expects the risk-free rate to remain at the current level for the next 10 years. In fact, we could easily see that rate at a much lower level in 12-18 months as it becomes clear that the interest rate hikes to date are having a big negative impact on economic growth. If the 10-year yield were to settle at 3.0%, the ERP would increase to about 2.6% – much closer to historical averages. Still, the ERP is more informative than the P/E multiple because it incorporates the level of interest rates into stock valuations.
Our calls for caution are suddenly looking more justified. This period of adjustment as the Fed keeps interest rates elevated in an effort to crush inflation could last a little while. This does not mean it’s time to give up on stocks. Missing just a few of the best trading days over long periods of time can dramatically impair long-term equity returns. Don’t be that person. Stay invested, but invested in quality companies that can endure what may come.
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