Financial charts indicate a decline in the "risk premium" for stocks, which some analysts associate with a potential market overvaluation and the risk of a correction. However, to accurately understand the situation, it is essential to consider a broader context.
What is the risk premium?
The risk premium is the additional return that investors expect for taking on risk. For fixed coupon bonds, this metric is relatively straightforward to calculate, as all the data is known: the size of the coupons, their dates, the yield on the bonds, and benchmarks. For instance, metrics like Option-adjusted spread or Z-spread indicate the excess return investors demand for credit risks.
Stocks and their characteristics
The situation with stocks is more complex. Companies do not have fixed cash flows; revenue, profit, and dividends fluctuate from year to year. In charts like those presented by The Daily Shot, the calculation of stock returns is based on dividing the expected net income for the next year by the price. This method simplifies reality by ignoring the dynamics of cash flow growth.
How to account for growth rates?
For stocks, it is important to consider the expected average growth rate of cash flows, which usually aligns with the nominal long-term growth rate of the economy. This figure includes real GDP growth and inflation. Since historical data on long-term growth rates is lacking, we in the company use an approximation: the average growth over the past 10 years plus the projected inflation for the next 10 years.
Current market situation
Our calculations indicate that despite the decline in the risk premium to 20-year lows, it remains significant. This reflects investor optimism regarding the U.S. economy. For comparison, it is useful to look at the risk premiums on corporate bonds rated B and CCC, which also carry a high level of risk. Such bonds exhibit similar premiums to stocks.
Important caveats
● The difference between stocks and bonds during crisis periods: the risk premium on bonds includes the probability of default, leading to inflated nominal yields that often do not reflect reality.
● Characteristics of stocks: stocks, as perpetual instruments, have a different return profile than bonds. Even during crisis periods, their multiples do not drop to extremely low levels.
Prospects for investors
Although the current risk premium may not indicate an imminent market correction, it is vital to consider the context. For example, falling interest rates and rising profit expectations may continue to support stock growth in both the short and long term.
Note: All charts and statistics from the original document have been preserved for clarity and to maintain analytical accuracy. If additional information or clarification is needed, it is available in the original data.