Is This the Best Opportunity to Buy Stocks in the Last 30 Years?

2022

The S&P 500 Index declined 19.44%  in 2022, the third worst annual loss in the last thirty years.  A rapid increase in interest rates, driven by inflation, contributed to the repricing of asset classes across the board.  A multitude of other factors contributed as well including the war in Ukraine and spiking commodity prices.  As we enter 2023 many of these macroeconomic risks are still present along with central banks hiking short-term interest rates into potential recessions.  With that said, the stock market broadly represented by the S&P 500 Index is priced over 19% lower than it was a year earlier.  How do we gauge the attractiveness of the current level given all the macro risks?

The Expected Return on Stocks

The expected return, not to be confused with a guaranteed return, is made up of two components:

1.      The “risk free” rate of return, and

2.      The equity risk premium (ERP)

Adding these two numbers together provides an expected rate of return.  How do we get there?

The Risk-Free Rate #1

The risk-free rate is the easy part, it is an observable rate of return available on a government bond.  At the beginning of 2023 the 10-YR Treasury offered 3.88% per-year for the next ten years.  A comparable risk-free rate hasn’t been offered since the beginning of 2010, thirteen years ago, when the 10-yr Treasury yielded 3.84%.

The Equity Risk Premium #2

The ERP is not observable and has to be estimated.  In addition, it changes over time.  Many market participants consider a reasonable ERP to be in a range of 4-6%, and this is a similar range to the actual earned premium in US stocks over different time periods.  The Equity Risk Premium is an incremental risk premium required to bear the risk, or volatility, of investing in stocks.  Think of it this way, if you can invest in government securities with no risk and earn 3.84% locked in for the next 10 years then why would you consider investing in stocks?   The answer is to earn prospective returns over and above that risk-free rate.  An ERP of 4-6% on top of 3.84% suggests an expected return on stocks in a range of 7.84%-9.84%.  This is a wide range, and we think there is a better way to estimate the ERP.  We are going to estimate an implied equity risk premium, rather than use a historical one, as a better way to estimate what is priced into the market at the current level.  This is consistent with forward-looking markets. 

For this paper we are going to lean on some data and research provided by NYU Professor Aswath Damodaran.  He’s been reporting on the ERP for many years, and we consider his academic research on the subject to be the very best.

Professor Damodaran’s Jan 1, 2023, update estimates an implied (forward looking) ERP of 5.94%.  This is towards the high end of the historical range.  Here is a snapshot of the forward-looking implied ERP going back to 1960:

(Source:  Prof. Aswath Damodaran)

There are some important takeaways from this chart:

• ·        The implied ERP has rarely been above 6%

• ·        Over the past twenty years the ERP has usually, but not always, been between 4-6%

• ·        There were decade long periods where the ERP was below 4%, beginning in the early 60’s and the late 80’s

Putting it all Together

The beginning of the year risk-free rate of 3.88% and an ERP of 5.94% suggests that the expected return on stocks is 9.82%.   Is this attractive?  At the beginning of 2023 the expected return on US stocks was at the highest level since the beginning of 1995, or 28 years ago, when it was 11.37%.  What was the actual total return over the next ten years (1996-2005)?  The realized return was 11.95%, remarkably close to the expected return estimate from a decade earlier. 

The following chart shows the risk-free rate in blue, with the ERP stacked on top of it in red, to give you the overall level of expected stock returns at the end of each year.

(Source:  Prof. Damodaran, Brave Eagle commentary)

Does This Model Actually Work

We constructed a chart comparing actual S&P 500 total returns Vs. expected returns.  We are comparing the expected return on stocks at the beginning of a decade with the actual total return earned over the next ten years.  You’ll notice that the chart ends in 2012.  This is because we are comparing the expected return on stocks at the end of that year with the actual earned over the next 10 years (2013-2022), this is the last ten-year period that we have.  At the end of 2012 the expected return on stocks was 7.54% and the actual total return from 2013-2022 was 12.44%.  In this case the model didn’t do such a great job as actual returns were almost 5% higher than expected.

 (Source:  Brave Eagle Wealth Management)

 Some takeaways:

• ·        During many periods the expected returns match up quite closely with the realized returns.  For example, from 1973-1986. 

• ·        During the 1960’s investors consistently earned positive returns, but less than they would have expected to earn, if they were using this model.  

• ·        Since 2009, actual returns have been substantially higher than expected returns.

• ·        There were only two rolling ten-year periods where investors earned negative returns on US stocks and they are visible on the chart at 1998 and 1999, meaning those returns periods ended in 2008 and 2009, during the Great Financial Crisis.  This is two out of fifty-two total periods.

• ·        The large difference between expected returns and actual returns starting in 1998 and a few years after are significantly impacted by calendar year 2008, a 36.55% loss for the S&P.  This is not surprising since a Black Swan event, by definition, would not have been priced in to expected returns at the end of 1998, or any years from 1998-2007 on the chart.

We can observe the difference between expected and actual returns in the following chart:

 Conclusion

As we entered calendar year 2023 many market risks were still present, but they’re not new risks.  Inflation is still too high, central banks are raising interest rates attempting to increase unemployment, there is an ongoing war in Eastern Europe, and energy security is still a threat in many countries.   The reward for bearing these risks to stock market investors comes in the form of the highest expected return on stocks in twenty-eight years, almost three decades. The expected return is made up of the highest risk-free rate available since 2010 and an equity risk premium of almost 6% and at the high end of the historic range.  This model has done a decent job over time estimating future returns, but it’s not perfect.  Actual returns will be impacted by future events that are unknown and are not priced in today.  That said, time has been the investors friend with positive ten-year compounded returns in all but two of the fifty two periods, or 96% of the time.  Importantly, the two ten-year periods with negative returns ending in 2008 and 2009 bookended the Great Financial Crisis drawdown of 57% that ended in March of 2009. 

We can’t know for sure if this will turn out to be one of the best times in the last thirty years to buy stocks.  However, at the beginning of 2023 the market was offering the second highest expected returns over the last thirty years.  Consistent with the current level of expected returns, we think it is far more likely than not that stock investors will do well over the next ten years.  We also believe that the path will not be a smooth one.  We think this is a good time for investors to reconsider their allocation level to stocks given the potential reward.  This is especially true for investors sitting on cash or in vehicles with very poor prospective outlooks like Stable Value Funds, which we think will struggle in a higher inflation environment.