Date: January 11, 2025
Overview
Since the market turbulence experienced from late summer 2021 through Q4 of fiscal year 2022, U.S equity markets have demonstrated a remarkable recovery. Since October 2022, the S&P500 Index has appreciated by nearly 79%, reflecting an approximate increase of 2,500 points. Productivity metrics, as measured by the U.S Productivity Index (I: USP), rebounded significantly during this period and remained positive throughout much of this bull market. This recovery has been bolstered by substantial advancements in technology, particularly the development and commercialization of artificial intelligence (AI). These innovations have enabled businesses across various sectors to achieve operation cost reductions and, in certain cases, expand their operations more effectively [Figure 1].
The economic impact of these advancements is evident in the rising levels of return on equity (ROE), driven by improved profitability. Greater bottom-line earnings have, in turn, generated strong cash flows, allowing firms to return increased levels of capital to investors through dividends and share repurchases [Figure 2]. Despite concerns about potential disruptions to labor markets stemming from rapid technological adoption, employment levels have generally risen during the majority of this bull market, further supporting economic and market growth.
However, this paper aims to analyze the potential for a near-term market correction or an outright recessionary decline in the value of U.S equities over the coming quarters. Specifically, our thesis is grounded in two primary factors :1) the valuation of the overall market, and 2) the implied equity risk premiums (ERP). For valuation, we utilize the price-to cash flow (P/CF) ratio, where cash flows are defined as the trailing twelve months’ aggregate of dividends and share repurchases by firms. This emphasis on cash flows, rather than earnings, is intentional; however, the specific rationale behind this choice falls outside the scope of this paper.
The calculation of implied equity risk premium relies on calculations akin to calculation of internal rate of return (IRR) for various cash flow generating assets but applied to the S&P500’s cash flows, as defined earlier. A two-step discount model is employed with the terminal growth rate aligned with prevailing U.S treasury bond yields, ensuring consistency with risk-free benchmarks.
This paper is structured as follows: first, we address the overarching narrative of market valuation, followed by an explanation of the concept and significance of implied equity risk premiums. Finally, we present the findings and conclusions derived from our research, offering insights into the current state of the market and potential future trends.
Valuation of U.S Equities
We turn our focus to what is arguably one of the most critical factors for equity investors: a stock’s valuation. The graph below presents a time series of the Price-to-Cash Flow (P/CF) ratio, illustrating the amount an average investor is currently willing to pay for each dollar f a company’s cash flow. Since the S&P500’s local trough in late 2022, investor sentiment has significantly driven up valuations. The willingness to pay has increased sharply, with the P/CF ratio climbing from $20 per dollar of cash flows to $35, reflecting a staggering 75% increase in the broader market’s valuation. This marked escalation places valuations in what could be considered precariously high territory, as evidenced by the data below.
While absolute valuation provides insight into investor sentiment and their willingness to pay, a single valuation metric alone cannot serve as conclusive evidence for active managers. As the adage goes, “Markets can remain irrational longer than you can remain solvent.” Expensive markets can sustain an uptrend for extended periods, just as cheap markets can persist in a downtrend. This inherent irrationality raises a critical question for investors: how can one gauge the timing of a potential from expensive to cheap markets, or vice versa?
This is where the concept of equity risk premium (ERP) becomes invaluable.
Equity Risk Premium
The equity risk premium (ERP), at its core, represents the compensation investors demand for assuming the additional risk of holding equities, which are subject to value fluctuations and potential losses, compared to the more stable returns from bonds. In this paper, we focus specifically on the implied equity risk premium- a forward-looking measure derived from current market conditions – rather than the historical ERP observed over time.
Preference for Implied Equity Risk Premium
Implied ERP has several advantages over other methods of calculating the equity risk premium. To understand this preference, it is important to consider an alternative approach and their limitations:
1. Survey-Based Premiums
One method involves surveying market participants to estimate ERP. However, this approach suffers from significant draw backs:
· Lagging Behavior: Surveyed ERPs tend to lag actual market conditions, often rising only after a bullish market phase and falling after a bearish phase.
· Subjectivity and Bias: The results can vary greatly depending on who is surveyed and how questions are framed, introducing behavioral biases and undermining reliability.
2. Historical ERP
Another common method is to calculate ERP based on historical data. While this provides context, it has its own set of challenges:
· Disparity in inputs: There is no consensus on the appropriate historical period to measure market returns, leading to significant variations in ERP estimates.
· Static nature: Historical averages may not capture dynamic shifts in the market, and reliance on fixed data intervals limits real-time applicability.
· Data variability: Different methodologies, such as using mean versus median values, further contribute to inconsistent results.
3. Implied ERP
Implied equity risk premiums address many of these issues by leveraging current market index levels and today’s estimates of future firm cash flows. This approach offers several key advantages:
· Timeliness: Implied ERPs are based on real time data and can be calculated at any moment, providing up-to-date insights compared to survey or historical measures that rely on infrequent updates.
· Reduced subjectivity: While some judgement call is required to estimate future cash flows and terminal growth rates, implied ERPs largely eliminate the behavioral and subjective biases that plague survey-based methods.
· Forward looking perspective: Because implied ERPs are derived from current market prices, which reflect expectations about future performance, they are inherently forward-looking rather than retrospective.
Methodology and Relevance of Implied ERP
The implied ERP is calculated using today’s index values, expected future cash flows (including dividends and share repurchases), and a discounting model akin to the internal rate of return (IRR) used in project finance. Terminal growth rates are typically set to match long-term treasury bond yields, ensuring consistency with prevailing market conditions.
These qualities make the implied ERP a powerful tool for understanding market sentiment and assessing valuation levels. As it reflects real-time market expectations, it offers a more accurate gauge of investor risk tolerance compared to backward-looking measures.
For further details on implied equity risk premiums and their calculation, Professor Aswath Damodaran’s extensive work on the subject provides an invaluable resource. (Visit: Professor Damodaran's website).
Determinants of ERP
To fully comprehend the nuances of the short thesis presented, it is essential to understand the key factors that drive the levels of the equity risk premium (ERP). In simple terms, what causes the ERP to rise or fall? Below are the primary determinants of ERP:
1. Risk Aversion and Consumption Preferences
Extensive academic research highlights that risk aversion tends to increase with age. Younger individuals, with longer investment horizons and fewer financial obligations, are generally more willing to take on higher-risk investments. In contrast, older investors, constrained by shorter horizons and greater financial commitments, often exhibit lower risk tolerance. This demographic shift influences aggregate risk preferences and impacts ERP levels.
2. Preference for Current Consumption
A higher preference for current consumption over future consumption typically contributes to a rise in the ERP. When economic agents prioritize immediate consumption, demand for risk-free assets increases, pushing equity risk premiums higher. Conversely, in periods where greater numbers of economic agents are net savers, the ERP tends to decline.
3. Economic Risk
Economic uncertainty significantly affects ERP levels. Factors such as inflation volatility, fluctuating interest rates, and variations in real GDP growth contribute to rising ERPs. Additional economic indicators like unemployment rates and other components of GDP also play a role in shaping equity risk premiums. Periods of heightened economic instability tend to correlate with elevated ERP levels.
4. Information
The quantity and quality of information available in the market influence ERP. Better access to accurate and timely information can reduce ERP, as investors are better equipped to make informed decisions. However, this relationship is not linear; an increase in information may sometimes lead to greater disagreement about a firm’s prospects, resulting in higher volatility and, consequently, a rise in ERP.
5. Liquidity and Fund Flows
Liquidity plays a crucial role in determining ERP. Academic studies extensively analyze the relationship between liquidity and risk, but its connection to broader market risk premiums is less frequently addressed. This gap is partly explained by the advent of highly liquid investment vehicles, such as exchange-traded funds (ETFs), which reduce transaction costs. Nonetheless, fund flows significantly impact ERP: greater liquidity, driven by increased fund inflows, lowers ERP, while reduced liquidity raises it.
6. Catastrophic Risk
Events like the Great Depression (1929–1930) or Japan’s economic downturn in the late 1980s exemplify catastrophic risks. Such events result in substantial, often unrecoverable, wealth losses, representing a significant factor in ERP determination. While the probability of such events is generally low, the risk of permanent wealth destruction underscores their critical impact on ERP.
7. Fiscal Policy
Uncertainty surrounding fiscal policy decisions can drive ERP higher. Policy shocks—such as changes in taxation, government spending, or regulation—contribute to heightened risk premiums. Greater ambiguity regarding government actions exacerbates investor uncertainty, raising ERP levels.
8. Monetary Policy
Similar to fiscal policy, monetary policy heavily influences ERP. Central banks manage market expectations through tools such as interest rate adjustments and signaling. For instance, a dovish monetary stance can lower ERP by instilling confidence in future economic growth. Conversely, restrictive monetary policies or unexpected rate hikes may elevate ERP by increasing perceived investment risk. Notably, monetary policy effects are often intertwined with broader economic risks, as central banks in developed economies typically respond to data-driven assessments of economic conditions.
Market Analysis : Current Market Conditions
Below is the graph of the monthly implied equity risk premium (ERP) observed in the market as of January 1, 2025. The graph tracks ERP levels since the end of 2008, revealing that current levels are hovering just above 4%. This represents an exceptionally low ERP within the context of the analysis timeline.
Adjusting the graph to include the average ERP, along with overlays of the mean ERP and ±1σ and ±2σ levels, reinforces our assumption of a low ERP environment, as shown below.
By overlaying the chart with the previously discussed valuation ratio, we arrive at the visualization below, which reinforces our cautious stance toward the U.S. markets today. This graph integrates the Price-to-Cash Flow (P/CF) ratio (on the left axis) with the equity risk premium (ERP) and its key historical deviation levels (on the right axis). It clearly demonstrates a counter-intuitive relationship between market valuations and the ERP: as market valuations increase, reflected in higher equity prices, the equity risk premium tends to decrease, and vice versa.
We interpret this relationship as a reflection of the broader market's shifting dynamics of fear and greed. As prices rise, the perceived risk in the market diminishes, fueling a self-reinforcing cycle of further price increases. This momentum continues until valuations or risk premiums reach extreme levels, signaling a peak in market greed or fear.
An important takeaway from this visual is that when equity risk premiums are at local peaks or bottoms—defined by their positioning relative to the upper and lower standard deviation levels—market corrections tend to follow.
For instance, consider the local bottoming of the ERP at the beginning of 2010. At that time, market participants were willing to pay approximately $29 per dollar of cash flow. Following this period, equity risk premiums saw significant appreciation, peaking near the end of 2011 and beginning of 2012. During this phase, market valuations declined sharply, with stock prices decompressing, which resulted in a reduced willingness to pay—down to approximately $16 per dollar of firm cash flows. Similar patterns of ERP fluctuations can be observed throughout the period, each having a meaningful impact on subsequent stock performance.
The accompanying graph of the S&P 500 further illustrates this dynamic. Red vertical bars on the chart mark periods of significant equity risk premium compression, which indicate the potential for rising risk premiums and weaker stock market performance. Conversely, green vertical bars highlight periods of significant ERP expansion, signaling a potential bottoming of equity prices.
Historically, the current implied ERP suggests that we are in a period of caution within the broader U.S. markets. This underlying thesis is largely contingent upon the behavior of equity risk premiums and the mean reversion of equities, which we will explore next.
Mean Reversion in ERP
The equity risk premium (ERP) is undeniably a mean-reverting measure, as evidenced by the market's cyclical shifts between fear and greed. Periods of heightened fear often give way to future phases of optimism, creating an ebb and flow driven by various behavioral factors. However, the mean-reverting nature of ERP extends beyond these psychological dynamics.
Several interconnected factors contribute to ERP's mean-reversion. Equity returns typically align with underlying economic growth and corporate earnings. A high ERP, which often arises during market declines or increased risk aversion, signals undervaluation, drawing investors back into equities and pushing prices up, thereby compressing the ERP. Conversely, a low ERP, driven by elevated stock prices or excessive optimism, signals overvaluation, leading to reduced demand for equities, lower returns, and an expanded ERP.
Additionally, the ERP is influenced by competition with alternative investments. It represents the premium investors demand over risk-free assets like government bonds. When the ERP is high, equities become more attractive relative to bonds, boosting demand and driving prices up, which compresses the ERP. Conversely, when the ERP is low, equities become less appealing, prompting capital outflows and higher future returns, thus expanding the ERP.
Beyond Theories of Mean Reversion
Consider the factors that can influence the equity risk premium (ERP) over time, and how they align with current market developments. One key driver of potential ERP fluctuation is fiscal instability, notably stemming from the uncertain outcomes of proposed policy changes by President-elect Donald Trump. A primary concern in this regard is the potential for tariffs on global trade, which present significant fiscal policy risks. Tariffs, typically associated with inflationary pressures due to reduced domestic supply, directly contradict the central banks' efforts aimed at fostering growth and maintaining price stability. This misalignment has, in turn, contributed to increased uncertainty in monetary policy decisions. A recent example of this uncertainty is reflected in the long-term bond market, where bond prices have declined sharply as long-term yields continue to rise, driven by concerns over inflation and stronger-than-expected economic growth coupled with an improving labor market.
Additionally, the recent outbreak of wildfires in California, with damages estimated in the billions of dollars, further compounds this uncertainty. Though the exact damage figures remain varied, insurance claims and other financial losses are expected to reach substantial amounts.
Finally, concerns about a potential recession have been amplified by the inversion of the yield curve, which has historically been a reliable indicator of recessions. However, it is important to note that the unwinding of this inversion may signal a shift in market dynamics. The yield spread and its implications are illustrated in the accompanying graph below.
Conclusion
The U.S. equity markets have experienced a remarkable recovery since late 2022, with the S&P 500 rising nearly 79%, fueled by advancements in technology and AI, and supported by increased profitability and cash flow. However, this paper argues that a market correction or recessionary decline may occur in the near future, focusing on two primary factors: the overall market valuation and the implied equity risk premium (ERP). Valuation is assessed using the Price-to-Cash Flow (P/CF) ratio, which shows a significant increase since late 2022, suggesting that valuations may be dangerously high. The ERP, particularly the implied ERP, is discussed as a crucial tool for assessing market sentiment, risk, and timing for potential market corrections.
We stand at a precipice: with valuations at extremes and sentiment complacent, the stage is set for a sharp downturn. The question is not if, but when. Is the market riding on the fumes of irrational exuberance, or will it face the inevitable correction that history demands
Appendix.
Figure 1. U.S Productivity Index [2022 – Latest]
Figure 2. U.S Net Income, Shareholder’s Equity & ROE [2022 – Latest]
Figure 3. Employment Level (U.S) [2022 – current]
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