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.