Market Valuation - Jan 2023

Adam Gould, CFA
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Key Takeaways
  • We use a residual income model to value the S&P 500. This framework indicated that the equity market was expensive last March and that poor equity returns would likely follow.
  • While the model continues to see the equity market as overpriced, it has become slightly less expensive in recent weeks, which we view as marginally positive for stocks.

Market Valuation: Equities Remain Expensive

We use a residual income model to value the market[1]. The residual income model produces an estimate for the equity risk premium, or the additional return that equity investors are compensated over the risk-free rate. Fig. 1 shows how the equity risk premium has trended over time.

Since the COVID-induced equity market selloff in early 2020, the equity risk premium has trended between 3-4%; it spent most of 2022 in that range. However, during fall of last year, the equity risk premium decreased sharply. At the end of October, the equity risk premium reached a multi-year low of 2.65%. As of January 24, the equity risk premium sat at 2.85%, below the historical range.

Fig. 1 – Equity Risk Premium from a Residual Income Model

Source: S&P, FactSet, Fundstrat analysis.Market Valuation - Jan 2023
Note: Shows equity risk premium from residual income model. Gray bars indicate recessions. Period of analysis is from January 2005 through January 24, 2023.

While the equity risk premium indicates the overall attitude of equity investors toward risk, it cannot, by itself, indicate the attractiveness of the equity market in a cross-asset framework.

We can compute an effective yield for the stock market by adding the equity risk premium to the risk-free rate. This effective yield allows us to compare the valuation of the equity market to that of other asset classes, particularly investment grade fixed income. Fig. 2 below shows the ratio of these yields – when the blue line in Fig. 2 is high (low), the equity market is relatively cheap (expensive).

Fig. 2 – Equity vs. Investment Grade Yield

Fig. 2 – Equity vs. Investment Grade Yield

Source: S&P, FactSet, Fundstrat analysis.Market Valuation - Jan 2023
Note: Shows ratio of equity yield to investment grade yield (blue line). Equity yield is computed as the sum of the 10-year Treasury yield and the equity risk premium derived from a residual income model. Investment grade yield is computed as the sum of the 10-year Treasury yield and the ICE BofA US Corporate Index Option-Adjusted Spread. Upper (lower) dashed black line shows the rolling 75th (25th) percentile observation using a rolling 60-month window. Period of analysis is from January 2006 through January 24, 2023.

Historically, there is a relationship between the yield ratio shown above and the performance of the equity market. Fig. 3 below shows the return and volatility of the equity market when the yield ratio shows equities as cheap, fairly valued, or expensive.

The yield ratio line above entered the “equities expensive” regime in March 2022, and has remained there since that time. Recently, however, the equity market has become marginally more attractively valued as the yield on investment grade fixed income has fallen. While the model still views equities as expensive, should this recent trend continue, we will once again enter the “equities fairly valued” regime which has historically produced better equity market returns.

Fig. 3 – Stock Market Performance Conditioned on Yield Ratio

Source: Ice Data Indices, LLC, retrieved from FRED, Federal Reserve Bank of St. Louis; January 23, 2023, FactSet.Market Valuation - Jan 2023
Note: Shows subsequent 3-month S&P 500 return (blue bars) and volatility (orange bars, right-hand axis) conditioned on the ratio of equity-to-investment grade yield. High (low) equity-to-investment grade yield is defined as the equity-to-investment grade yield being above (below) the 75th (25th) percentile observation using a rolling 60-month window. Medium equity-to-investment grade yield is when the equity-to-investment grade yield is between the 25th and 75th percentile observations (using a rolling 60-month window). Period of analysis is from January 2006 through January 24, 2023.

Conclusion

In this note, we update our market valuation framework that compares the yield of the equity and investment grade fixed income markets. In March of last year, the valuation framework indicated that equities were expensive, which has historically led to poor equity market returns.

While the framework continues to rate the equity market as overpriced, the equity market has become less expensive over the past few weeks. Should this trend continue, we may see better equity market returns going forward.

[1] See Our Market Valuation Report

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Adam Gould, CFA, the research analyst denoted by an “AC” on the cover of this report, hereby certifies that all of the views expressed in this report accurately reflect his personal views, which have not been influenced by considerations of the firm’s business or client relationships. Neither I, nor a member of my household is an officer, director, or advisory board member of the issuer(s) or has another significant affiliation with the issuer(s) that is/are the subject of this research report. There is a possibility that we will from time to time have long or short positions in, and buy or sell, the securities or derivatives, if any, referred to in this research.
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