Equity Risk Premium Part 1: Why was the S&P 500 trading higher in August 2023 despite 10Y Treasury rates climbing?
What's Equity Risk Premium, why it's important, what drives it & how to measure it
On October 13, 2022, S&P 500 was trading at 3491. The US 10Y bond rate was 4.33% (Real Rate = 1.75%, Breakeven Inflation = 2.58%).
Yet on August 28, 2023, S&P 500 was trading at 4433, when the 10Y bond rate stood at 4.21% (Real Rate = 1.90%, Breakeven Inflation = 2.31%), S&P 500 was trading at 4433.
3414 vs. 4433.
That is, on Aug 28, 2022, S&P 500 was trading 21% higher despite the 10Y bond and TIPS being higher than October 2022.
What is the story?
Enter The Equity Risk Premium.
Let’s explore the basics.
If I invested in a 10Y US bond today on Aug 28, I would earn a return of 4.22%. This is called a risk-free rate.
In other words, it is guaranteed that I earn a return of 4.22% at the end of the maturity of the 10 Y bond.
This is because the US Treasury bond is deemed to be the safest asset class in the world
Now, if I choose to invest in other risk assets (such as equities, real estate, corporate bonds, etc.), I am logically not going to settle for a risk-free rate of return on the asset. The risk asset needs to offer me an additional premium on top of the risk-free rate, so I have the incentive to invest in it.
In the case of equities, the additional premium on top of the risk free rate is called Equity Risk Premium. Therefore, if I choose to invest in equities, my expected rate of return will be the sum of the Risk free rate and Equity Risk premium.
Expected Return on Equity = Risk free Rate + Equity Risk Premium
So, what drives the value of the Equity Risk Premium?
The Equity Risk Premium is not a fixed number. It is driven by a number of factors such as
Economic Uncertainty
Inflation and Interest rates
Earnings growth
Natural disasters
Government policy
Monetary policy and more…
We are going to focus on the first 3 factors and its impact on the Equity Risk Premium in this post.
Furthermore, from here onwards, when I talk about Equity Risk Premium, I am referring specifically to The Equity Risk Premium of the S&P 500.
So, let’s dive in to understand how the first 3 factors drive the Equity Risk Premium of S&P 500.
Economic Uncertainty: As economic uncertainty stabilizes and improves, investors’ risk appetite rises. As the appetite rises because of improving economic conditions, the Equity Risk Premium desired by investors on top of the risk free rate goes down.
Actual Inflation vs. Expected Inflation: The future cash flows of financial assets are priced based on expected inflation and interest rates.
If Actual Inflation = Expected Inflation: Equity Risk premium remains stable.
If Actual Inflation< Expected Inflation: Equity Risk Premium declines (all things equal). Financial assets are repriced higher to reflect lower than expected inflation and interest rates.
If Actual Inflation> Expected Inflation: Equity Risk Premium rises (all things equal). Financial assets are repriced lower to reflect higher than expected inflation and interest rates.
Earnings growth vs. Expectation: Similar to the path of inflation and interest rates,
If Earnings growth = Expectation: Equity Risk Premium remains stable.
If Earnings growth >Expectations: Equity Risk Premium falls and financial assets are repriced higher to reflect higher than expected growth.
If Earnings growth<Expectations: Equity Risk Premium rises and financial assets are repriced lower to reflect lower than expected growth.
Let's understand how the the drivers of Equity Risk Premium have evolved since Oct 2022 to date.
Key Observations
In the Economic (Un)certainty segment, we can see see that,
Consumer Sentiment has improved 10 b.p.s since Oct 2022 till date.
Consumer Confidence has improved overall, across Present Situation and Expectation Index
NFIB Small Business Index has also seen a small uptick on a YoY basis.
Overall, from an Economic Certainty standpoint, we are in a better place today than last year in Oct 2022.
In the Inflation Expectation segment, we can see that,
Core PCE has come down from 5.2% to 4.2% on a YoY basis.
Effective Fed rates are up, but they are currently topping out, which indicates that peak rates are most likely in to curb inflation down to the long term Fed target of 2.2%.
This is also reflected in the 10Y Breakeven Inflation component of the 10Y bond yield which has come down from 2.58% to 2.3%. Further, similar gauges such as NY Fed survey of Inflation expectation has also drastically come on a YoY basis.
Therefore, we can say that as Core Inflation is coming down, overall expectation of future core inflation is also coming down, which is further supported by the inflation data that is coming at or below expectation. As inflation expectation stabilizes, so does the expectation of discount rate on future cashflows. As a result, this generally has a positive effect on the stock market pricing.
Finally, in the Earnings Growth Expectation segment, we can see that,
In FY 2022, the Actual Earnings per share for the S&P 500 came 2% below expectation.
So far, in FY 2023, we are seeing better than expected results for Q1 and Q2. As a result, Earnings Estimates for FY 2023 has been revised up. The same is true for FY 2024 estimates, where we are seeing upward revisions this year.
Upward revisions in earnings estimates has positive effect on stock market pricing and vice versa.
So, how do we measure the Equity Risk Premium?
By now, it is becoming increasingly evident that as economic, inflationary and earnings expectations improve better than expected, it reprices equity markets to go higher.
This is fueled by rising investors’ risk appetite.
This in turn pushes down the Equity Risk Premium, as investors desire lesser premiums to invest in risky assets.
And why so?
General Human psychology. When times are good, we expect it will continue forever.
Now, there are 2 main methods to calculate the Equity Risk Premium.
Method 1: Earnings yield to Risk free rate
Method 2: Implied Equity Risk Premium
In this post, we are going to learn how to calculate the Equity Risk Premium using Method 1.
This is how it works:
S&P 500 was trading at 4433 on Aug 28, 2023. Earnings Estimate for S&P 500 2023= $220.3. Therefore, Price to Earnings Ratio = 20.12.
Given Price to Earnings Ratio = 20.12, Earnings yield = 4.9%.
Yield on 10 Y bond on Aug 28, 2023 = 4.22%
Therefore Equity Risk Premium = 0.7%
In other words, given the pricing in markets today, equity investors are rewarded an additional 0.7% on top of risk free rate of 4.22% to invest in equities.
To illustrate, I have attached the following chart from Charlie Billelo
In Part 2, I discuss the Implied Equity Risk Premium Method, which is a fundamental approach to estimating an internal rate of return on stocks, given pricing and cash flows.
This is the preferred method of Aswath Damodaran, whose teachings I have followed since 2020 to drive my investment philosophy with logic, clarity and rigor.
I then present the various paths S&P 500 can take based on the macroeconomic scenarios, and the impact it may have on the Equity Risk Premium, given the path of inflation and earnings growth.
You can read Part 2 below:-
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As I understand, we must also reduce the CD Spread from 10Y bond to arrive at Risk Free Rate. This may be push up the ERP above 1% in this computation
I may be wrong also.
This is an excellent analysis, Amrita.