ERP and how expensive is the US market now?

The US market is expensive. Less expensive than it was a few days ago before the yield curve inverted and the S&P500 had several days of large losses, but expensive still. But how expensive is it really?

The Cyclically Adjusted Price Earnings (CAPE) or Shiller PE ratio is 28.5. Although this is down from January 2018 where it stood at 33.3, the only other time’s it has been this high was in January 2000 (followed by years of poor returns) and Black Tuesday (of Great Depression fame.)

The standard PE ratio of 21.1 is high too, but not perhaps to the same degree as the CAPE ratio. This indicates that current earnings and relatively higher (compared to their historical average) than the average of earnings over the last 10 years (compared to the historical average of that measure over time.) This is, after all, the point of the CAPE ratio – it recognises that earnings are cyclical and that a simple PE ratio isn’t that predictive. In other words, recent earnings are high by compared to the last ten years.

Still, none of this is really good news for future performance on the S&P. However, is the situation really as dire as it seems? What impact did the 2008/2009 earnings period have? Do the extremely low interest rates in the US have a part to play here?

Any time part of a measure includes several prior years, it is worth considering what happened in that ten period and if there are any specific base year effects. The only one I’ll mention here is that the cyclically adjusted earnings part still includes the catastrophically low earnings period around 2008/2009. In another 6 to 12 months most of this effect will have disappeared and the CAPE ratio will decline all on its own

My prospective Equity Risk Premium (ERP) estimation tool takes US 10 year nominal yields (1.6%) and real yields (0.2%), the current S&P500 dividend yield (2.0%) and expected real GDP growth of 2% to realise an ERP of 3.8%.

The GDP forecast is the crucially subjective estimate. With population growth of just 0.7% per annum, estimates for medium term GDP growth of between 2% and 3% imply fairly significant per capita growth so I’m more comfortable with 2% than 3%. The 0.8% decline in population growth over the last 50 years (from 1.5% in the 1960s) means some gut feel estimates of achievable GDP growth still reflect this higher growth period.

As a sensitivity on this uncertain input, 3% GDP growth implies an ERP of 4.8%.

The reasonable long term range for an ERP is either 2% to 4% or 3% to 5% depending on who you ask. (There are also those who mis-estimate this and end up with 8% to 10%, but I’ve blogged extensively before on the ERP estimation flaws that are required to get those estimates.)

Whichever range you work with, actual market implied ERPs of 3.8% to 4.8% do not look unusually low, and therefore do not suggest the US market is quite as expensive as some other measures suggest. What is missing here is a time series of market implied ERPs.

In summary, the US market is likely expensive, and there are enough risk factors around to concern an investor. However, I don’t think it’s quite as dire as some have indicated.

Published by David Kirk

The opinions expressed on this site are those of the author and other commenters and are not necessarily those of his employer or any other organisation. David Kirk runs Milliman’s actuarial consulting practice in Africa. He is an actuary and is the creator of New Business Margin on Revenue. He specialises in risk and capital management, regulatory change and insurance strategy . He also has extensive experience in embedded value reporting, insurance-related IFRS and share option valuation.

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