The risk of a US stock market correction viewed from the bond market
US equities would have to fall about 25% to return the risk premium over bond yields to more normal levels.
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US equities have been very expensive for a long time when judged using simple measures of long-term valuation.
In valuing equities against bonds, US equities have historically paid a large risk premium above the risk-free rate, but this premium is currently at a historically low level, albeit not at the extremes of the dot-com bubble.
Defining the equity risk premium as the difference between the forward earnings yield and the real government bond yield*, the premium for the S&P 500 has averaged 4.6pp over the almost forty years for which data are available (the premium for the Nasdaq has averaged 3.6pp over the past twenty-five years for which there are data).
The equity risk premium for the S&P in October was well below this average at 2.9pp (or 2.1pp for the Nasdaq), although it has been around this low level for a couple of years now (or a few years in the case of tech stocks).
By design, these long-term metrics are not meant to provide a timing signal for the market, although, to provide an insight into what a sustained stock market correction could look like, the S&P 500 would have to fall by about a quarter to return the equity risk premium to its average level assuming broadly no change in earnings (about the same for the Nasdaq).
Realistically, though, in a scenario of a sustained stock market correction, a return to a more normal equity risk premium would also involve lower bond yields.
Note: * the 10-year real bond yield is the median of a number of estimates.
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Based in Sydney, Kieran Davies is Chief Macro Strategist at Coolabah Capital Investments, an asset manager with 65 executives and over $20 billion in fixed-income strategies. Kieran is responsible for macroeconomic research and investment strategy, contributing to the investment decisions of the firm. Kieran has long experience as a macroeconomist in both the private and public sectors. He has worked most recently as Chief Markets Economist for National Australia Bank and was previously Chief Economist, Australia and New Zealand, for Barclays Bank and ABN Amro Bank/RBS. Kieran also worked as Principal Adviser on the macroeconomy and budget policy in the Commonwealth Treasury and Director of Forecasting.
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Based in Sydney, Kieran Davies is Chief Macro Strategist at Coolabah Capital Investments, an asset manager with 65 executives and over $20 billion in fixed-income strategies. Kieran is responsible for macroeconomic research and investment...
Based in Sydney, Kieran Davies is Chief Macro Strategist at Coolabah Capital Investments, an asset manager with 65 executives and over $20 billion in fixed-income strategies. Kieran is responsible for macroeconomic research and investment...
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