CWS Market Review – March 26, 2024

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The Equity Risk Premium Goes to Zero

The stock market did something recently it hasn’t done in over 20 years. The yield on the 10-year Treasury exceeded the earnings yield for the S&P 500.

What am I talking about? Let’s dive in.

By earnings yield, I mean the S&P 500’s earnings divided by its price. That’s the inverse of the market’s price/earnings ratio.

To be more technical, the equity risk premium has gone to zero. Typically, one would expect a benefit from owning stocks. According to the theory, this is the reward shareholders get for shouldering more risk. Sometime the benefit is a lot, sometimes it’s a little. Right now, it doesn’t exist.

Here’s a look at the yield on the 10-year Treasury (in black) along with the S&P 500’s earnings yield (in purple).

Here’s how it works, or at least how it’s supposed to work (my apologies for getting mathy).

Take the 10-year Treasury yield. Right now, that’s around 4.25%. Add 2% to that for the risk premium (so 6.25%). Then take the inverse of that (1/0.0625 = 16) and that should roughly be the stock market’s price/earnings ratio. In this case, that’s 16.

Except, right now, it’s not even close. The stock market’s current price/earnings ratio is currently at 24. That’s roughly 50% higher than where the model thinks it should be.

As of Friday, the 10-year Treasury yield was 4.27% while the earnings yield of the S&P 500 was 4.10%. That means that investors are being punished by 17 basis points for owning stocks. This is also why we pay so much attention to what the Fed has to say about interest rates.

Let me add some very cautious words about this kind of analysis. I’m not a fan of trying to model the stock market. Many have tried but the market gods have left many a ruined spreadsheet in their wake. To quote Isaac Newton, “I can calculate the motion of heavenly bodies, but not the madness of people.”

The model isn’t saying that stocks are overpriced. Rather, it’s saying that stocks are richly valued relative to bonds compared with previous periods. That’s quite a different takeaway.

Here’s a look at the Equity Risk Premium which is how much stock investors are being paid to buy stocks instead of bonds.

Still, even bad models can make a point. This one is telling us a very basic fact that we can’t ignore. That is that stock prices have gone up a lot over the past five months. Meanwhile, bond prices have been creeping lower.

At some point, bonds are a better deal than stocks. I don’t know where that line is, but I do know two things: it’s out there somewhere, and we’re much closer to it than we’ve been in quite some time.

This isn’t to scare you. I have no plans to sell all my stocks, but it’s responsible to ensure that investors are aware of the current climate.

Interestingly, stocks reached their most recent low point in late October right as the 10-year Treasury peaked near 5%. (It came very close to breaking above 5% but couldn’t quite do it.)

Since then, stocks have rallied, and the 10-year Treasury yield fell, but that came to an end just before New Year’s. We went from Stocks-Up, Bonds-Up to Stocks-Up, Bonds-Down. The first one can last a long time, but the second one is a lot less stable. Last week, the 10-year yield got above 4.3%.

While I don’t plan on selling anything, I certainly can understand the mindset of some investors who look at the current prices and realize that they can sit out the volatility of the stock market and lock-in, say, a one-year Treasury for 5%. That’s the equivalent of 2,000 Dow points. For zero risk!

It’s not for me, but I get why some people are happy to take it. This shows us how distorting higher interest rates can be. This also tells me that sometime soon, the Fed will cut rates not because it wants to, but because it has too.

The odds of a rate cut in June are at 70%, and that rises to 84% for a cut by July. The odds for two cuts by July are low (now around 30%). It may soon be that we’ll get one cut, in June or July, but which month isn’t yet clear.

The Reddit Rally

Last week, I told you about the weakness in many defensive sectors. That’s exactly the outcome of diverging stock and bond markets. Last week, I mentioned how one of our favorite defensive stocks, Hershey (HSY), has been acting poorly of late. This is exactly the kind of stock that leads the market when the economy gets soft.

I mentioned that the chocolate giant has been squeezed by higher cocoa prices. Due to heavy rains in west Africa, there’s been a massive shortage of cocoa. That’s where 70% of the world’s cocoa comes from. So far, Hershey has been able to pass along some of these price increases.

Cocoa is outperforming Nvidia this year. Earlier today, BNP Paribas Exane downgraded Hershey from outperform to neutral.

The cocoa rally, however, has gone into overdrive, and Easter is one of the biggest times of the year for chocolate consumption. For the first time ever, cocoa is trading north of $10,000 per metric ton. Hershey says it predicts flat earnings this year. At some point soon, I expect cocoa prices to plunge back to earth.

But this is a different outcome from the same driver. Investors are ignoring risk. Cocoa isn’t the only place we’re seeing surging prices. Last week, Reddit (RDDT) went public, and the stock has performed very well.

I wanted to show you just how extreme some of the valuations are. Let’s take a closer look at Reddit’s business.

Last year, Reddit had revenue of $804 million and operating income of negative $140 million. In other words, the company is running at an operating loss. Add in $50 million in other income and Reddit lost about $90 million for the year. That works out to minus 57 cents per share.

Despite running a loss, shares of Reddit were priced at $34. Once trading started, the shares took off. Earlier today, the stock came close to $75 per share. That means the business is trading for more than 130 times its loss from the year.

I understand that one shouldn’t value nontraditional companies with traditional metrics. Still, at some point, one has to view this as extreme. This is exactly what happens when the equity risk premium goes to zero. When being risky pays off, the market will follow what’s working.

Reddit is worth $75 per share in the same way cocoa is worth $10,000 per metric ton, or the S&P 500 is worth 24 times earnings. “The voice of reason is small, but very persistent.” — Sigmund Freud.

That’s all for now. I’ll have more for you in the next issue of CWS Market Review.

– Eddy

P.S. If you want more info on our ETF, you can check out the ETF’s website.

Posted by on March 26th, 2024 at 6:34 pm


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.