Professor Aswath Damodaran of the NYU Stern School of Business sees it as a receptacle for investor hopes and fears
15 Jun 2013 08:55
BY TEH HOOI LING
GLOBAL equities markets - especially those outside of the US - have gone on roller-coaster rides since the US Federal Reserves chairman Ben Bernanke suggested on May 22 that the central bank was poised to taper off its money printing action.
Here are the numbers. In Singapore, the Straits Times Index has fallen 8.4 per cent in the last three and a half weeks - giving back all the gains that it had made so far this year.
Hong Kong's Hang Seng Index is down nearly 10 per cent since May 22, and it is down 7.4 per cent for the year. Nikkei 225 has plunged by just under 20 per cent in the last three and half weeks, but it is still up 22 per cent for the year. The South Korean and Taiwanese markets are down by about 5 per cent each since the topic of "tapering" was broached. The former is also down by about 5 per cent for the year but the latter still manages to cling on to a 3 per cent gain year-to-date.
Meanwhile, Jakarta is down 8.6 per cent since the third week of May, but is still up 10 per cent for the year. As for the US, the S&P 500 shed only 1.1 per cent since May 22, and is in the black by nearly 15 per cent for the year.
All the above numbers are in local currency terms. Given the strengthening of the US dollar, the US market's gain is even higher and the losses in some of the regional markets more severe.
Three weeks back, I calculated the equity risk premia (ERP) for some of these markets and showed that these risk premia - the expected compensation to investors for exposing themselves to equity risk - are high by historical standards.
I calculated the ERP by dividing the 10-year average earnings per share of the market by the current market price, and then subtracted the one-year interbank rates. The high levels of ERPs suggest that the markets are not overvalued, and in fact, there may still be room for further appreciation, I noted.
Aswath Damodaran, professor of finance at the Stern School of Business at New York University, in his latest blog post, added a new perspective to the discussion on ERPs.
Comparing the expected cash flows of US stocks relative to the S&P 500 as at May 18, Prof Damodaran came up with an ERP of 5.45 per cent. "The ERP is the extra return that investors demand over and above a risk free rate to invest in equities as a class. Thus, it is a receptacle for investor hopes and fears, with the number rising when the fear quotient dominates the hope quotient. In buoyant times, when investors are not fazed by risk and hope is the dominant force, equity risk premiums can fall," explains Prof Damodaran.
The average implied equity risk premium between 1961 and 2012 in the US is 4.02 per cent. If the equity risk premium, currently at 5.45 per cent, does drop to 4.02 per cent, the S&P 500 would trade at 2,270, an increase of some 38 per cent from current levels.
Prof Damodaran adds more granularity to the discussion on the ERP. "The high ERP in 2013 is very different from high ERPs in previous time periods and extrapolating from past history can be dangerous," he says.
The expected returns of stocks have two components - one, the risk free rate; and two, the ERP.
Prof Damodaran plots the expected returns of stocks from 1962 till last year, and decomposes them into ERP and the risk free rates. (See chart)
He notes that over the last decade, the expected return on stocks has stayed surprisingly stable at between 8-9 per cent. Almost all of the variation in the ERP over the decade has come from the risk free rate. In particular, the higher ERP over the last five years can be entirely attributed to the risk free rates dropping to historic lows. In fact, the expected return on stocks on May 18, 2013 of 7.40 per cent is close to the historic low for this number of 6.91 per cent at the end of 1998.
While the relationship between the level of the ERP and the risk free rate has weakened over the last decade, the two numbers have historically moved in the same direction, says Prof Damodaran. When risk free rate goes up, so does ERP, leading to lower stock prices.
In light of this, consider again two periods with high ERPs. In 1981, the ERP was 5.73 per cent, but it was on top of a 10-year US treasury bond (T.bond) rate of 13.98 per cent, yielding an expected return for stocks of 19.81 per cent. On May 1, 2013, the ERP is at 5.70 per cent but it rests on a US treasury bond rate of 1.65 per cent, resulting in an expected return on 7.35 per cent.
"An investor betting on ERP declining in 1979 had two forces working in his favour: that the ERP would revert back to historic averages and that the US treasury bond rate would also decline towards past norms. An investor in 2013 is faced with the reality that the US T.bond rate does not have much room to get lower and, if mean reversion holds, has plenty of room to move up, and if history holds, it will take the ERP up with it," he says.
But there is some good news. Even if risk free rates move to 3 per cent and the equity risk premium drops to 5 per cent, the S&P 500 index is still undervalued by about 5 per cent, according to Prof Damodaran's calculations. But if rates rise to 4 per cent and the equity risk premium stays at 5.5 per cent, the index is overvalued by about 8 per cent.
So there is still some room for the rates to move around before the market is deemed overvalued.
In a previous post, Prof Damodaran has noted that stocks do not look overpriced based on (1) robust cash flows, taking the form of dividends and buybacks at historic highs for US companies, (2) a recovering economy (and earnings growth that comes with it), (3) ERP at above-normal levels and (4) low risk free rates.
Thus, he says his argument is a relative one: given how other financial assets are being priced and the level of interest rates right now, stocks look reasonably priced.
The danger, though, is that the US T.Bond rate is not only at a historic low but that it may be too low, relative to its intrinsic level, based upon expected inflation and expected real growth.
"If you believe that the T.Bond rate is too low, then you have the possibility that you are in the midst of a Fed-induced market bubble(s) and that script never has a good ending," he cautions.
The scary part is that there are no obvious safe havens: gold and silver have had a good run but don't seem like a bargain and central banks around the world seem to be following the Fed's script of low interest rates. "You could use derivatives to buy short-term insurance against a market collapse but, given that you are not alone in your fears about the market, you will pay a hefty price."
So the market is dancing to the Fed's tune. It is not a question of whether the music will stop, but when, writes Prof Damodaran. "When long-term interest rates move back up, as they inevitably will, the question of how much the equity markets will be affected will depend in large part on whether the ERP declines enough to offset the interest rate effect."
But while Prof Damodaran says he would not be arguing that stocks are cheap, simply because the ERP today is higher than historic norms, he is not ready to scale down the equity portion of his portfolio (especially since he has no place to put that money).
As mentioned, there is enough room for rates to move around before the market is considered severely overvalued.
Hence Prof Damodaran says he will continue to buy individual stocks, while keeping an eye on the ERP and T.Bond rate.
Hopefully, the above analysis will soothe the nerves of some investors out there. Just a note, the professor shares his research and views on his blog frequently and readers can download spreadsheets to input their own numbers to come up with their own conclusions. Therefore, the blog should be a frequent stop for investors keen to continually improve on their investment knowledge.
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