If asked to list the biggest threats to US equities at the start of 2016, most people would have pointed to the Federal Reserve’s imminent retreat from quantitative easing and the possibility of a slowdown in China spilling into lower global growth. Those fears contributed to a very bad start to 2016 for US stock markets, and as stocks dropped by about 5% in January, those who have warned us about a bubble looked prescient. But the stock market, as is its wont, surprised us again. Not only did US equities come back from those setbacks but it weathered other crises during the year, including the decision by UK voters to exit the EU in June and by US voters to elect Donald Trump as president in November to end the year with healthy gains. As we enter a year with potentially big changes to the US tax code and trade policy looming, it is time to take stock of where we are and where we might be going in the next year.
Stocks and Bonds: Looking Back
The best place to see how the year unfolded for stocks is to trace out how the S&P 500 (large cap stocks), the S&P 600 (for small cap stocks) and US ten-year treasury bond rate did on a month by month basis through 2016.
To convert the index values into returns each month, I first computed price changes for the indices each month (and cumulatively over the year) and added the dividends for the year to estimate annual returns of 11.74% for the S&P 500 and 26.46% for the S&P 600; it was a very good year for small cap stocks and a good one for large cap stocks. I converted the treasury bond rates into bond price changes each month and cumulatively (for a 10-year constant maturity bond) over the year and added the coupon at the start of the year to get a return of 0.58% for the year; the rise in interest rates cause bond prices to drop by 1.68% during the year.
To put these returns in perspective, I added the S&P 500 and treasury bond return for 2016 to my historical data series which goes back to 1928 and computed both simple and compounded (geometric) annual averages in both for the entire period and compared them to a annualized 3-month treasury bill return (which you can think of as the return for holding cash).
This table (or some variant of it) is used by practitioners to get the equity risk premium for US markets, by subtracting the average return on treasuries (bills or bonds) from the average return on stocks over a historical time period. Using my estimates, I get the following values for the historical equity risk premium for the US market.
Note that the equity risk premium varies widely, from 2.3% to 7.96%, depending on how long a time period you use, how you compute averages (simple or compounded) and whether you use treasury bills or bonds as your measure of a risk free investment. Adding a statistical note of caution, each of these estimated premiums comes with a standard error, reported in red numbers below the estimated number. Thus, if you decide to use 6.24%, the difference between the arithmetic average returns on stocks and bonds from 1928-2016, as your historical risk premium, that number comes with a standard error of 2.26%. That would mean that your true equity risk premium, with 95% confidence, could be anywhere from 1.72% to 10.76% (plus and minus two standard errors).
Stocks: Looking forward
Looking at the past may give us comfort but investing is always about the future. I have been a long-time skeptic of historical risk premiums for two reasons. First, as noted in the table above, they are noisy (have high standard errors). Second, they assume mean reversion, i.e., that US equity markets will revert back to what they have historically delivered as returns and that is an increasingly tenuous assumption. It is for this reason that I compute a forward-looking estimate of the equity risk premium for the US, using the S&P 500 Index as my measure of US stocks. Specifically, I estimate expected cash flows from dividends and buybacks from holding the S&P 500 for the next five years, using the trailing 12-month cash flow as my starting point and an expected growth rate in earnings as my proxy for cash flow growth and use these estimates, in conjunction with the index level on January 1, 2017, to compute an internal rate of return (a discount rate that will make the present value of the expected cash flows on the index equal to the traded level of the index).
Given the level of the index (2038.83 on January 1, 2017) and expected cash flows, I estimate an expected return on 8.14% for stocks and netting out the T.Bond rate of 2.45% on January 1, 2017, yields an implied ERP for the index of 5.69%. That number is down from the 6.12% that I estimated at the start of 2016 but is still well above the historical average (from 1960-2016) for this implied ERP of about 4.11%.
There is one troubling feature to the trailing 12 month cash flows on the S&P 500 that gives me pause. As was the case last year, the cash flows returned by S&P 500 companies represented more than 100% of earnings during the trailing 12 months, an unsustainable pace even in a mature market. I recomputed the ERP on the assumption that the cash payout ratio will decrease over time to sustainable levels, i.e., levels that would allow for enough reinvestment given the growth rate. The results are shown below:
The implied ERP for the index, with payout adjusting to about 82.3% of earnings in year 5, is 4.50%, still higher than historic norms but with a much slimmer buffer for safety. Looking at the next year, though, the potential for tax law changes will roil estimates. Not only are many analysts expecting significant increases in earnings next year of 12-15%, as they expect corporate tax rates to get lowered (at least in the aggregate) but there may also be a return of some of the trapped cash ($2 trillion or higher) back to the US, if that portion of the law is modified. Either change will relieve the pressure on cash flows and make it less likely that you will see dramatic cuts in stock buybacks or dividends.
Interest Rates: What lies ahead?
With bonds, I will take a different tack. I believe that, rather than waiting on the Fed, the path for interest rates this year will be determined by the