What’s going on with the market?
With all that has taken place recently in the markets, we wanted to take a step back and describe what we believe is happening. Understanding what the effects of rising rates, along with future earnings, have on the market is important to understand what’s going on. While there are several aspects that can drive market sentiment and direction, risk and reward are still at the core.
Understanding Risk Premium
(Corporate Earnings/Index) – Risk Free Rate = Risk Premium
First, we must understand what Risk Premium is. In basic terms it is the rate of return one expects to earn above a risk-free rate (i.e. U.S. Treasuries) for taking on risk. To calculate the risk premium of the S&P you need three things, a risk-free rate, S&P Index, and the forward earnings of the S&P.
– 1 Year US Treasury – 2.64%
– S&P Index – 2641
– Forward Earnings of the S&P – 175.20
To find the earnings based anticipated rate of return for the S&P divide 175.20/2641 = 6.63%
To get the Risk Premium, subtract the 1 Year Treasury yield from anticipated return, 6.63% – 2.64% = 3.99%
At the time of this writing (10/29/2018), one would expect to earn an additional 3.99% for taking on the risk of investing in the S&P. For context on Oct 1, 2018 the S&P 500 Index was 2924 and the 1 Year US Treasure was 2.60% that works out to roughly a 3.39% risk premium.
Ok, now what?
The Fed is currently raising the Fed Funds rate to normal levels which in turn impacts other rates including the 1-year Treasury. (Read more on how HERE – St. Louis Fed). As the 1-year rate rises that reduces the premium you receive for holding riskier assets, i.e. the S&P. For example, if the 1-year goes to 2.75 that means the premium would go from 3.99% to 3.88% (6.63%-2.75%). At some level, investors must determine whether or not the premium is worth the risk.
With a basic understanding of Risk Premium now let’s look at the 3 ways the premium can change.
1. Through Earnings. If the earnings expectations come down from 175.20 the rate of return or earnings one would expect to receive would come down too. This would narrow the difference between the risk-free rate and the earnings from holding the riskier asset. The opposite is also true. If the earnings are better than expected, the premium would increase.
– Potential current impacts – Too high earnings expectations, tariffs, rise of the US Dollar, cost of servicing debt, or earnings exceeding expectation.
2. Through Rates. While the Fed doesn’t directly control the 1-Year U.S. Treasury Rate, they do indirectly have an impact along with supply and demand of buyers and issuance of additional bonds.
– Potential current impacts – Fed’s language and action, Fed reducing its balance sheet, not enough buyers to meet increased issuance of bonds to meet budget deficit,
3. Through Prices. Lower stock prices will raise the risk premium by raising the earnings yield. Conversely, higher stock prices would lower the risk premium.
What does this mean?
Currently the market is doubting next year’s earnings growth of roughly 10% for the S&P. Additionally, the market is taking Fed Chairman Powell at his word that he is willing to overshoot finding a neutral rate over undershooting. Both reduce the risk premium we just discussed and therefore we have the market going down to get to a level where investors are willing to step in. This doesn’t mean that a recession is near nor should we run for the hills. At any point we could hear different language from the Fed, that China and U.S. are making headway on trade, or other positives for earnings or rates. We do, however, need to understand the risk we are willing to take and why we are willing to take it at a given point in time.
In times of volatility it is important to have a plan, so we don’t react to day to day swings. Having a financial and investment plan is important to achieving your goals over the long-term, because over the long-term the bulls have always won. And as Warren Buffet recommends to those that are properly invested for their goals, “stay away from your investment portfolio” and to go “get ice cream with their kids and say hi to a friend they haven’t spoken to in a while.” Great advice.