Leading into 2021, the big questions facing investors were about how quickly economies would recover from COVID, with the assumption that the virus would fade during the year, and the pressures that the resulting growth would put on inflation. In a post at the start of 2021, I argued that while stocks entered the year at elevated levels, especially on historic metrics (such as PE ratios), they were priced to deliver reasonable returns, relative to very low risk free rates (with the treasury bond rate at 0.93% at the start of 2021). At the start of 2022, it feels like Groundhog Day, with the same questions about economic growth and inflation looming for the year, and the same judgment about stocks, i.e., that they look expensive. In this post, I will begin with a historical assessment of stock returns in the recent past, then move on to evaluate the returns that investors can expect to make, given how they are priced at the start of 2022, and end with a do-it-yourself valuation of the index right now.
The year that was….
If equity markets surprised us with their resilience in 2020, not just weathering a pandemic for the ages, but prospering in its midst, US equity markets, in particular, managed to find light even in the darkest news stories, and continued their rise through 2021. Foreign markets, though, had a mixed year, and that divergence is worth noting, since it may provide clues to what may be coming in the next year.
US Equities, in the aggregate
US equities had a good year, by any measure, with the S&P 500 rising from 3756 at the start of 2021 to end the year at 4766, an increase of 26.90%. While that followed another good year for stocks in 2020, with the index rising 16.25%, from 3231 to 3756, the index took different pathways during the two years:
Looking at the 94 years in this dataset, the returns in 2021 would have ranked 20th on the list, good, but not exceptional. Note, though, that 2021 is the third consecutive year of very good returns on the index, with 2019 delivering 31.21%, and 2020 generating 18.02%, and that the cumulative return over the three years (2019-21) is 98.95%. If you compute cumulative returns, on a rolling three-year time period (1928-30, 1929-31, 1930-32 etc.), the 2019-21 time period would rank 8th on the list of 92 3-year time periods. The table below provides the rankings for returns over 5-year and 10-year periods, and where the most recent three-year, five-year and ten-year cumulative returns would rank on the list:
In sum, if you have money to invest over the last decade, and you stayed invested, you should count yourself as lucky to have enjoyed one of the great market runs of the last century. Conversely, if you stayed out of the market, for the last decade, you would have committed one of the great investing mistakes of all time, and blaming the Fed or bubble-talk will not bring you absolution.
US Equities, by sub-group
It has always true that when markets move, up or down, not all sectors and sub-groups are treated equally. I do believe that too much is often made of these differences, as it is generally more the rule than the exception that markets, when they are up strongly, get the bulk of that rise from a small sub-set of stocks or sectors. Using S&P’s sector classification, I take a look at how each one did in 2022, looking at the percent changes in market capitalization:
In contrast to 2020, when technology and consumer discretionary firms ran well ahead of the pack, the best performing sectors in 2021 were energy and real estate, two of the biggest laggards in 2020. That can be viewed as vindication, at least in this year, for contrarians, but as a cautionary note for ESG advocates, who assumed that fossil fuel companies were on a death march, based upon their performance over the last decade.
There is no debate more likely to draw heat than the value versus growth debate, and at the risk of being labeled simplistic by value investors, I looked at returns on companies, in 2021, based upon their PE ratios at the start of 2021:
Unlike 2020, where high PE stocks beat low PE stocks decisively, the results in 2021 were mixed, with no clear patterns across the classes. The results are similar if you break stocks down based upon price to book ratios or revenue growth rates. Finally, and in keeping with my fixation on corporate age and life cycles, I broke companies down by company age (measured from the founding year):
Again, unlike 2020, when young companies delivered significantly higher returns than older companies, the best returns in 2021 were delivered by middle aged companies.
For the rest of the world
While US equities continued to set new highs in 2021, the picture in the rest of the world was not as rosy, as you can see in the table below (with percent returns in US dollar terms):
In US dollar terms, India had the best-performing market in 2021, following a strong 2020, but China, the best performer in the world in 2020 came back to earth in 2021. North America (US and Canada) outperformed the globe, but Latin America was the worst performing region, down more than 20% in US dollar terms. There are many reasons why markets diverge, but here again the contrast with 2020 is worth drawing. In 2020, the COVID crisis played out across markets, increasing the co-movement and correlation across developed markets, with the US, Europe and Japan moving mostly in sync. In 2021, you saw a return to more normal times, with markets in each country affected more by local factors.
The Price of Risk in Equity Markets
The allure of having the historical data that we do in financial markets, especially in the United States, is that there is information in the past. The danger of poring over this historical data is that a focus on the past can blind us to structural changes in markets that can make the future very different from the past. To get a measure of what equity markets are offering in terms of expected returns, we are better served with a forward-looking and dynamic measure of these returns, and that is the focus of this section.
Implied Equity Risk Premiums
To understand the intuition behind the implied equity risk premium, it is easiest to start with the concept of a yield to maturity on a bond, computed as the discount rate that makes the present value of the cash flows on the bond (coupons, during the bond’s lifetime, and face value, at maturity) equal to the price of the bond. With equities, the cash flows take the form of dividends and buybacks, and in addition to estimating them using future growth rates, you have to assume that they continue in perpetuity. In computing this implied equity risk premium for the S&P 500, I start with the dividends and buybacks on the stocks in the index in the most recent year (which is known) and assume that they grow at the rate that analysts who follow the index are projecting for the next five years. Beyond the fifth year, I make the simplifying assumption that earnings growth will converge on the nominal growth rate of the economy, which I set equal to the risk free rate.
If you set the present value of the expected cash flows equal to the index level today, and solve for a discount rate (you may need to use the solver function in Excel, or trial and error), the resulting number is the expected return on stocks, based upon how stocks are priced today, and expected cash flows. This approach is built on the proposition that the intrinsic value of stocks is the present value of the expected cash flows that you generate in perpetuity, from holding these stocks, but it is model agnostic. Put simply, it does not require that you believe in any risk and return model in finance, since it is based on price and expected cash flows. To the critique that analysts can over estimate future earnings and growth, the response is that even if they do (and there is no evidence that top-down forecasts are biased), it is the price of risk, given expected cash flows.
The Implied ERP – Start of 2022
I have computed the implied equity risk premium at the start of every month, since September 2008, and during crisis periods, I compute it every day. Over the course of 2021, as the index rose, risk free rates climbed and analysts got much more upbeat about expected earnings for the next three years, the equity risk premium drifted down, to end the year at 4.24%:
Much as I would love to claim that I have the estimated the equity risk premium to the second decimal point, the truth is that there is some give in these numbers and that changing assumptions about earnings and cash flows generates an equity risk premium between 4-5%. The contrast between the behavior f equity risk premiums in 2020 and 2021 are in the picture below, where I show my (daily) estimates of ERP during 2020 on the left, and my (monthly) estimates of ERP for 2021 on the right.
During 2020, the equity risk started the year at about 4.7%, spiraled to almost 8% on March 23, 2020, before reverting back quickly to pre-crisis levels by September 2020. During 2021, you saw equity risk premiums revert back to a more sedate path, with numbers staying between 4% and 5% through the course of the entire year.
As talk of a bubble fills the air, one way to reframe the question of whether stocks are in bubble territory is to ask whether the current implied equity risk premium has become “too low”. If your answer is yes, you are arguing that stocks are over priced, and if the answer is no, that they are under priced. At least on the surface, the current level of the equity risk premium is not flashing red lights, since at 4.24%, it is running slightly above the long term averages of 4.21% (1960 – 2021).
That said, there are two reasons for concern. The first is that the premium is now lower than the average premium since 2008, a period that perhaps better reflects the new global economy. The second and scarier reason is that the 5.75% expected return that is implied in today’s stock prices is close to a sixty-year low:
A pessimist looking at this graph will conclude that expected returns on stocks have become too low, and that we are due for a correction, but that would be more a statement about treasury bond rates being too low than about equity risk premiums. Even if you belong to the camp arguing that low risk free rates are now the norm, this graph suggests that we all need to re-examine how much we, as individuals, are saving for retirement, since the old presumption that you can earn 8-10% investing in stocks will longer hold. Across the United States, defined-benefit pension funds that have set aside funds on this same assumption will face massive funding shortfalls, unless they reevaluate benefit levels or infuse new funds.
A Market Assessment
If you look at history, it seems difficult to argue against the notion that market timing is the impossible dream, but that has never stopped investors from trying to time markets, partly because the payoff from being right is immense. I have long claimed that I am not a market timer, but that is a lie, since every investor times markets, with the difference being in whether the timing is implicit (with cash holdings in your portfolio increasing, when you feel uneasy about markets, and decreasing, when you feel bullish) or explicit (where you actively bet on market direction). Rather than just give you just my estimate of whether I think the market is under or over valued, I will ask each of you to make your own judgments, while also offering my own.
The process of valuing the index starts with an assessment of expected earnings, and with the S&P 500, there is no shortage of either historical data or assessments of the future, on this dimension. Let’s start with a look at S&P earnings over time:
While COVID wreaked havoc with corporate earnings in 2020, the comeback in earnings in 2021 has been remarkable, with trailing 12-month earnings (October 2020 – September 2021) at 190.34, and estimated earnings for 2021 of 206.38, both significantly higher than the 162.35 that was earned in 2019 (pre-COVID). At the end of 2021, analyst estimates for earnings in 2022 and 2023 reflect their views that the earnings recovery will continue:
I will use the analyst estimates as my expected earnings for the index for the next two years, but assume that earnings growth rate thereafter will move down over the following three years to a stable growth rate (set equal to the risk free rate). It is true that analysts are often wrong, and in some cases, biased, but the latter is more of a problem with analyst estimates for individual companies, than for market aggregate earnings. However, if you believe that analysts have overestimated earnings, my valuation spreadsheet gives you the option of haircutting those estimates. Conversely, if your contention is that analysts are still playing catch-up, you can increase their estimates by a factor of your choosing.
Investors don’t get value from earnings directly, but do get value from the cash flows flowing from those earnings. As I have noted in prior posts, these cash flows, which used to entirely take the form of dividends, have increasingly shifted, over the last three decades, to stock buybacks.
While dividends are stickier than buybacks, insofar as companies are more willing to reduce the latter during crisis years like 2009 and 2020, it is also clear, as the comeback in buybacks in 2021 shows. In my base case valuation, I will start with 77.36%, the percent of earnings that companies have returned to shareholders, in dividends and buybacks, in the last twelve months, but I will increase this over time to a cash payout ratio that is consistent with my estimate of stable growth (risk free rate) and the return on equity of 16.10% that S&P 500 companies have earned, on average, over the last decade. (Sustainable Payout Ratio = 1 – g/ ROE; with a 16.10% return on equity and a 2.5% growth rate, the payout ratio in stable growth is 84.47%= 1 – .025/.161).
On the risk free rate, I start with 1.51%, the 10-year treasury bond rate on January 1, 2022, but I will assume that this rate will drift upwards over the next five years to reach 2.5%. That reflects my view that inflation pressures will push up long term rates in the year to come and has little to do with what the Fed may or may not do with the Fed funds rate. Finally, I build in the expectation that a fair ERP for the S&P 500 should be 5%, higher than the long term historical average of 4.21%, but closer to the average ERP since 2008. On both these macro assumptions, I encourage you to take your own point of view. With these assumptions in place, my valuation for the S&P 500, as of January 1, 2022, is shown below:
Note that even in the two weeks since I did this valuation, there have been material changes in key inputs, with the treasury bond rate rising to 1.87% on January 19, 2022, and the S&P dropping to 4533, down 3.8% from its level at the start of the year.
As with any valuation, I don’t believe that I should try to convince you that my valuation is the right one, nor do I have no desire to do so. In fact, I know that my valuation is wrong, with the question being in what direction, and by how much. I would strongly encourage you to take my valuation spreadsheet, change the numbers that I have used on earnings, cash flows, the risk free rate and the equity risk premium to reflect your views, and come up with your own assessment of value. Good investing requires taking ownership of your investment decisions, and trusting this choice to talking heads on TV, market strategists at investment banks or those market gurus who looked good last year is a dereliction of investment duty.
Datasets (to download)
- Historical returns on stocks, bonds, bills and real estate: 1928 – 2021
- Historical implied ERP on the S&P 500: 1960 -2021
Spreadsheet (to value the S&P 500)