Analysis: Timid bulls may keep U.S. equity risk premiums high

By Edward Krudy

NEW YORK (BestGrowthStock) – Despite a sizable rally since the autumn, investors are still attaching a hefty risk premium to stocks. Bulls hope improving valuations will lead stocks higher next year, but some investors remain skeptical.

The S&P 500’s price-to-earnings ratio – a yardstick showing what investors are willing to pay for a dollar of S&P earnings – is about 13, based on 2011 earnings estimates, below the mean of 17 since 1988.

But investors only expect that to rise to about 14 in 2011, implying a steady rather than a sharp move higher for stocks. Some analysts predict that risk aversion could stay elevated for several years as investors avoid paying big bucks for earnings.

“I don’t believe investors are going to pay up for earnings as the market is still trying to determine whether it’s an inflationary or deflationary period,” John Lynch, chief equity strategist at Wells Fargo Funds Management, said.

“Then you have to throw in the state in municipal finance, sovereign debt, deficit spending … those are other examples that are going to keep a lid on multiples.”

Based on average 2011 per-share earnings estimates for S&P 500 companies of about $96 and an average year-end S&P 500 target of 1,325, according to Reuters data, most analysts expect the P/E multiple to expand to 14 by year-end.

That is still below the average over the last two decades, and is particularly notable, given low interest rates and as companies have been consistently beating earnings estimates.

The risk-averse mind-set persists given the reverberations still emanating from the financial crisis. One banker dealing with wealthy U.S. families said confidence in institutions, including markets, banks and government, is at rock bottom.

Europe’s shaky financial state, the sudden concerns in the municipal finance market and worries over the U.S. budget deficit are all lingering in the background.

As Venu Krishna, head of U.S. equity-linked strategies at Barclays Capital recently put it, “Events which we thought would not happen have certainly happened on a fairly consistent basis … the likelihood of something going wrong is high.”


Jim Paulsen, chief investment officer at Wells Capital Management, says low interest rates and the strength in earnings justifies a P/E ratio of as much as 20.

Paulsen’s theory is that a risk averse “new normal mania” is keeping valuations low just as a “conservative mania” did in the 1950s. He believes that is creating a major investment opportunity to snap up cheap equities.

Paulsen said when interest rates and inflation are at the low end of their average range in the last 125 years, P/E ratios are generally at the high end of theirs.

The 10-year Treasury bond is currently yielding 3.4 percent while the equity yield on the S&P 500 is nearly 8 percent. Since the financial crisis, the spread between the two is at its highest in at least 20 years, according to data from T. Rowe Price.

However, William Delwiche, an investment strategist at Robert W. Baird & Co in Nashville, said the relationship between bond yields and equity yields doesn’t hold when interest rates are stretched to recent levels.

“If things are getting so bad that we need to have super-low interest rates, why would you then correspondingly want to have a super-high P/E ratio?” he said. “When you’re at the ‘normal’ balance, maybe there’s some relationship there, but at extremes it breaks down.”

Delwiche points out margins at S&P 500 companies are at or near record highs, while expectations are also are high. He believes those factors counterbalance high earnings yields and the earnings track record. Those margins are expected to decline, and if they do, it would justify the concerns of those wary of running stocks higher.

In addition, interest rates are far more likely to rise than fall in coming months. Some analysts say that the yield on the 10-year could hit 4-5 percent next year, a likely headwind for stocks.

So far equity investors are not sold by the idea that equities are cheap. A total of $273 billion has flowed out of equity funds since 2008 while more than double that has gone into bond funds, and the money continues to flow, according to data from the Investment Company Institute.

Even during September, when the S&P 500 rallied 9 percent, $14.4 billion left domestic equities.

BlackRock’s Bob Doll, who advises on $317 billion in managed funds, points out that money goes where prices are rising. For investors to start rerating equity risk in a meaningful way, more are going to have to take the plunge.

(Reporting by Edward Krudy; Editing by Kenneth Barry)

Analysis: Timid bulls may keep U.S. equity risk premiums high