Have US equities gone too far this time?

Less attractive but still preferable over bonds in the long run

The preferred method to form long run equity return expectations are done by adding the current dividend yield and estimated buyback yield. For the S&P 500 the current dividend yield is 1.5% and the 2-year average buyback yield is 2.2%. For many multinational companies it is more tax efficient to return capital to shareholders through buybacks than dividends. These two figures equate to a combined capital return yield of 3.7%. Assuming these capital return estimates can be held over a 10-year period the capital return yield should grow with long run expected real GDP growth. This is estimated to be around 2.2%. Adding the long run real GDP growth and the capital return yield equates to an annualised real expected return of 5.9% at the current level and under the assumptions described.

In the bond market things are a bit easier because the return is known in advance. The current 10-year yield by the end of January was 3.91% and US 10-year zero coupon inflation swap was 2.46%. The inflation swap market is a hedging market in which market participants can swap cash flows based on the CPI Index and subtracting the swap rate from the US 10-year yield gives the investor a real return on bonds. In January, the market priced real return on US 7-10 year treasuries was 1.46%. Compared to 5.9% in equities investors are not offered the better deal in the long run in government bonds. The difference is called the real equity risk premium. In other words, how much are you as an investor compensated for taking equity risk (uncertainty about economic outlook, productivity, innovation, bankruptcy, and balance sheet).

As the chart below shows, the real equity risk premium has shrunk to low levels for the period since 2006 and it is arguably lower than the historical average. But if you as an investor care about long run returns and accumulating wealth then the US equity market is still offering a better deal than government bonds. When we look at the chart it also become clear why the equity valuation chart in isolation is difficult to use. In late 2021, equity valuations were very high and one could have made the conclusion that equities were bad in the long run from those levels However, in real equity risk premium terms equities offered a spread of 6%. How is that possible? At the time the US 10-year yield was as low as 1.4% and the 10-year inflation swap was at 2.7% translating into a negative real return of negative 1.3%. Yes, equities were overextended and there was a bubble in certain technology segments, but the biggest bubble was in government bonds because it did not adequately price inflation risks.

When interest rates started rising in 2022 on the back of the Fed’s aggressive move on policy rates, bonds plummeted pushing up the cost of capital. The only natural reaction in equities was lower equity valuations, but also because higher interest rates were expected to push the economy into a recession. That did not happen, and US equities have since moved to new all-time highs in total return terms while US 10-year government bonds are still in a drawdown confirming where the real bubble was.

For the long-term investor a final observation is important to understand. The US equity market has returned 9.1% annualised since December 2004 and US 7-10 year government bonds have in the same period only delivered 3.4% translating into an equity risk premium of 5.7% annualised. Compounding in equities is magic for wealth creation. Bonds still play a role in asset allocation and in private investor portfolios. Especially, as the investor ages and has less time to recoup large drawdowns which are part of the risk you assume as an investor in equities.

Recent notes on equities

Tesla earnings review: Between two mountain tops?