Skip to main content

The shrinking (US) Risk Premium

As the US stock market continues to climb and reaches "record-high" levels, questions on overvaluation and bubbles become more common. Robert Shiller CAPE measure of the US stock market shows now a market that is at a higher level than during the Great Depression. The market has only been more expensive in the years 1998-2000 in the run up to the burst of the internet bubble.

While high CAPE values signal potential overvaluation, one has to compare those numbers to levels of interest rates to assess whether stock prices are truly overvalued relative to other asset prices. One simple way to compare the two is to calculate the stock market risk premium implied by current levels of stock prices, earnings, nominal interest rates, expected inflation as well as expectations of future earnings growth. In previous posts I have explained in detail the data and methodology to calculate the risk premium. Below is the most updated analysis including the value of 10-year interest rates that just hit 2.642% today.


A combination of higher stock prices and increasing interest rates has led to a sharp decrease in the risk premium which is quickly approaching 4%. Not far from the values in 2007. But, of course, still really far from the 1990s bubble. 

So the market is becoming more expensive and either investors are expecting an improvement in long-term growth expectations relative to the potential growth estimates from CBO or they are willing to accept a lower risk premium. A lower risk premium seems like a surprise to some given that there are good reasons not to ignore downside risks in 2018.  

While none of these valuation measures are perfect predictors of future returns, stock market bubbles are always preceded by rising prices and decreasing risk premium - signals that the market is underestimating risk. Today, these ingredients are becoming more obvious in US stock markets. Maybe these indicators are not that useful to understand stock prices and it is all about "narratives" (as Robert Shiller argues), but all narratives come to an end when some of the risks are materialized and markets have to face reality.

Antonio Fatás

Comments

Post a Comment

Popular posts from this blog

The permanent scars of economic pessimism

Gavyn Davies at the Financial Times reflects on the growing pessimism of Central Banks regarding the growth potential of advanced economies. In the US, the Euro area or the UK, central banks are reducing their estimates of the output gap. They now think about some of the recent output losses as permanent as opposed to cyclical. It output is not far from what we consider to be potential, there is less need for central banks to act and it is more likely that we will see an earlier normalization of monetary policy towards a neutral stance. Why did they change their mind? Is this evidence consistent with the standard economic models that we use to think about cyclical developments? Measuring potential output or the slack in the economy has always been challenging. One can rely on models that capture the factors that drive potential output (such as the capital stock or productivity or demographics) or one can look at more specific indicators of idle capacity, such as capacity utilization or...
Post a Comment
Read more

The 2020 (US) Recession

Summary: This post is based on a research note I wrote asking whether low unemployment is sustainable. The answer is a clear no for the US. Low level of unemployment are good predictors of the tail risk event of a recession, a sharp increase in unemployment rates. These dynamics are related to the build up of financial and macroeconomic imbalances. If this pattern is to repeated, and given the current level of unemployment rate, a US recession must be around the corner. For details on the analysis, the research note including additional results is available on my web site: Fatas (2019) . A few months away from the longest US expansion The US economy is a few months short of beating the longest expansion ever, which took place from March 1991 to March 2001. As we approach this milestone, there are increasing concerns about the possibility of a recession in the coming years. Do expansions die of old age? The empirical evidence suggests that this is not the case. There is no clear correla...
Post a Comment
Read more

German economic policy and chameleons

Wolfgang Munchau's FT article today is one of the most complete explanations I have seen about the origin and contradictions of the German economic orthodox dogma. The only issue that he does not address is how these economic views have survived over time despite the increasing evidence that their advice does not deliver the expected results. Here is my guess from what I have learned from many heated discussions over the last years about economic policy in Europe: the resilience (stubbornness) of this view on economic policy comes from a combination of faith and the inability of the economic profession to apply enough real world filters to models. Faith in a certain economic model comes from many years of being trained about the beauty of markets and all the inefficiencies that governments generate. But faith also comes from the belief that only through (individual) hard work and sacrifice (saving) one can achieve any economic progress. In this world (what Wolfgang Munchau refers ...
Post a Comment
Read more