Market Valuation: Equities Remain Expensive
We use a residual income model to value the market. The residual income model produces an estimate for the equity risk premium, or the additional return that equity investors are compensated over the risk-free rate. Fig. 1 shows how the equity risk premium has trended over time.
Since the COVID-induced equity market selloff in early 2020, the equity risk premium has trended between 3-4%; it spent most of 2022 in that range. However, during fall of last year, the equity risk premium decreased sharply. At the end of October, the equity risk premium reached a multi-year low of 2.65%. As of January 24, the equity risk premium sat at 2.85%, below the historical range.
While the equity risk premium indicates the overall attitude of equity investors toward risk, it cannot, by itself, indicate the attractiveness of the equity market in a cross-asset framework.
We can compute an effective yield for the stock market by adding the equity risk premium to the risk-free rate. This effective yield allows us to compare the valuation of the equity market to that of other asset classes, particularly investment grade fixed income. Fig. 2 below shows the ratio of these yields – when the blue line in Fig. 2 is high (low), the equity market is relatively cheap (expensive).
Fig. 2 – Equity vs. Investment Grade Yield
Historically, there is a relationship between the yield ratio shown above and the performance of the equity market. Fig. 3 below shows the return and volatility of the equity market when the yield ratio shows equities as cheap, fairly valued, or expensive.
The yield ratio line above entered the “equities expensive” regime in March 2022, and has remained there since that time. Recently, however, the equity market has become marginally more attractively valued as the yield on investment grade fixed income has fallen. While the model still views equities as expensive, should this recent trend continue, we will once again enter the “equities fairly valued” regime which has historically produced better equity market returns.
In this note, we update our market valuation framework that compares the yield of the equity and investment grade fixed income markets. In March of last year, the valuation framework indicated that equities were expensive, which has historically led to poor equity market returns.
While the framework continues to rate the equity market as overpriced, the equity market has become less expensive over the past few weeks. Should this trend continue, we may see better equity market returns going forward.