Markets

Christopher Langner is a markets columnist for Bloomberg Gadfly. He previously covered corporate finance for Bloomberg News, and has written for Reuters/IFR, Forbes, the Wall Street Journal and Mergermarket.

The S&P 500 has set several records this year and as it tests new limits, more commentators are calling a top. Are they right? The question resonates far beyond New York, since the U.S. benchmark gauge influences stocks around the world.

The answer depends on which metric you choose to focus. Looking at cyclically adjusted price-earnings ratios or elevated profit margins, a case can be made that the market is due for a fall. But by at least one measure, this rally has more room to run.

The equity risk premium measures the excess return that investors can hope to earn over the risk-free rate. The S&P 500 currently promises 7.64 percentage points of additional return compared with the 10-year U.S. Treasury bond, according to data compiled by Bloomberg. That's close to the 7.9 percent average of the past five years and well above the 6.4 percent low touched in April 2010.

The risk premium can be considered an inverse measure of market over- or under-valuation. The lower the extra return demanded by investors to put their money in stocks, the more highly valued the market is. Conversely, the higher the premium, the cheaper stocks are.

Neither Top Nor Bottom
The risk premium on the S&P 500 is near the average of the past five years, suggesting it's not overvalued
Source: Bloomberg

By this measure, the S&P doesn't look unduly expensive, even after a rebound that's driven the index up by 19 percent from February's low.

Caveats are necessary when using the equity risk premium. The figure is an estimate of future returns. Since the future is uncertain, that may turn out to be wrong. Unlike bonds, with their set coupons and repayment dates, stocks don't mature and dividends are discretionary. The risk premium is the extra reward that investors get for holding these more uncertain and volatile assets.

Total expected returns for the S&P index -- as opposed to risk premiums alone -- have been declining and are close to their lowest in at least a decade. The culprit here, though, is falling interest rates. 

Far From Stellar
The S&P's total expected returns are near the lowest in at least a decade
Source: Bloomberg

Risk-free rates around the world have never been this low. The yield on the 10-year U.S. Treasury dropped below 1.36 percent for the first time ever on July 8, while the equivalent rates in Japan and Europe are negative. 

Printing Presses
Benchmark interest rates have never been this low
Source: Bloomberg

This can also be seen as a positive for stocks, though. Other things being equal, lower interest rates should mean higher valuations. One way of valuing equities is to calculate the present value of future estimated dividends. A lower discount rate equals a higher price. The complicating factor is that today's ultra-low rates reflect pessimism over the global economy and, by extension, corporate earnings prospects.

Still, next to the near-zero or outright negative yields on government bonds, stocks still look far from over-stretched. The other good news is that companies in the S&P 500 are in better financial shape than in the past, having reduced debt since the global financial crisis. While they've started leveraging up again, they're nowhere near the historic average.

Time to Gear Up
In spite of record low interest rates, companies have a lot less debt now than 30 years ago
Source: Bloomberg

When companies take on more debt, return on equity increases. So there could be better earnings ahead. Given how many markets tend to track the performance of U.S. shares, this could mean gains for stock investors across the globe. 

Equity strategists at Citigroup note that equity risk premiums are higher than at previous market peaks in 2007 and 2000. Europe and Australia offer the best rewards, they conclude.

It won't be all smooth sailing. August is traditionally one of the worst months for equity markets and there are still uncertainties that could undermine the long march up. As it stands, though, the next S&P 500 record is unlikely to be the last.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Christopher Langner in Singapore at clangner@bloomberg.net

To contact the editor responsible for this story:
Matthew Brooker at mbrooker1@bloomberg.net