US stocks rose to their most expensive levels relative to government bonds in a generation, amid growing jitters among some investors over high valuations for huge technology companies and other Wall Street stocks.
Standard run for us stocks, which Hit high fresh On Wednesday, it pushed the so-called forward dividend yield—expected earnings as a percentage of stock prices—on the S&P 500 to 3.9 percent, according to Bloomberg data. The Treasury sell-off sent 10-year bond yields as high as 4.65 percent.
That means the difference between the two, or a measure of what's called the equity risk premium, or the additional compensation to an investor for the risk of owning the stock, has fallen into negative territory and last reached a level in 2002 during the Dotcom Boom and bust.
“Investors are effectively saying 'I want to own these dominant technology companies and I'm willing to do that without a huge risk premium,'” said Ben Enker, co-head of asset allocation at asset manager GMO. “I think that's a crazy position.”
Analysts said the sharp US stock valuations, described as “The mother of all bubbles“, if fund managers are demanding exposure to the country's booming economic profits and companies, as well as a belief among many investors that they cannot afford to risk leaving the so-called seven hot tech stocks from their portfolios.
“The questions we are getting from clients are, on the one hand, concerns about market concentration and how heavy the market has become,” Enker said. “But, on the other hand, people are asking 'Shouldn't we just own these dominant companies because they're going to take over the world?' “
The traditionally constructed equity risk premium is sometimes known as the “FED model,” because Alan Greenspan seemed to refer to it at times when he was chairman of the Federal Reserve.
However, the model has its picks. A 2003 paper by Cliff Asness, founder of the fund firm AQR, criticized the use of Treasury yields as an “irrelevant” nominal benchmark and said the equity risk premium failed as a predictive tool for equity returns.
Some analysts now employ an equity risk premium that compares the earnings return of stocks with adjusted US bond yields. On this reading, the stock's risk premium is also “at its lowest levels since the Dotcom era,” said Miroslav Ardsky, senior analyst at BCA Research, though it's not negative.
Aradski added that the premium may reduce the fact that the shares are expensive Stocks.
Given that profit margins are higher than their historical average, if they were to “return toward their historical norms, earnings growth could end up being very weak.”
Some market watchers are looking at completely different measures. Aswath Damodaran, a finance professor at New York University's Stern School of Business, is sharply critical of the Fed model and said the correct way to calculate a stock's risk premium is to use cash flow projections and cash payout ratios.
By his calculations, the equity risk premium has fallen over the past 12 months, and is close to the lowest level in the past 20 years, but “certainly not negative.”
The valuation of stocks relative to bonds is just one measure of the exuberance reported by managers. Others include evaluating US stocks' price-to-earnings history against their history or comparing them to stocks in other regions.
“There are quite a few red flags here that should make us a bit cautious,” said Chris Jeffrey, head of asset management at Legal & General. “Most comforting is the difference between the way U.S. stocks and non-U.S. stocks are priced.”
Many investors argue that high multiples are justified and can continue. “It's undeniable that (US stock prices) are multiple relative to history, but that doesn't necessarily mean it's higher than it should be, given the fundamental environment,” Goldman Sachs Senior Equities said. Strategist Ben Snyder.
On Goldman's own model, which indicates what the PE ratio for a U.S. blue-chip equity index should be, after taking into account the interest rate environment, labor market health and other factors, the S&P is “in line with our typical fair value,” Snyder said.
“The good news is that earnings are growing, and even with unchanged valuations, earnings growth should push stock prices higher,” he added.
US stocks have now regained all the ground lost during the fall since December. The sell-off highlighted some investors' fears of a level of Treasury yields that the stock market pool couldn't live with, because bonds—a traditional haven asset—would look too attractive.
Pimco's chief investment officer said This week, relative valuations between bonds and stocks are “as broad as we've seen in a long time,” and the same policies that may take bond yields threaten to push stocks higher.
For others, the lower risk premium in US stocks is just another reflection of investors accumulating in big tech stocks and the risks that concentration in a small number of big names poses to portfolios.
“Although momentum is strong in MAG 7, this is the year you want to be diversified in your equity exposure,” said Andrew Pace, chief investment strategist at Russell Investments.
