- Our model estimates a market-implied U.S. equity risk premium (ERP) similar to average levels of the last decade, even though price-to-earnings ratios have approached levels unseen since the dot-com bubble.
- The model attributes high prices largely to the low-yield environment, which also implies a total expected equity return over the next decade much lower than the realized return of the 2010s.
- The market-implied ERP, a forward-looking risk-premium measure, indicates that appetite for risk has recovered to a pre-COVID level. Propped up by historically low real rates, U.S. equity valuations are consistent with a scenario of moderate recession.
The U.S. equity market rebounded strongly following the historic crash in March 2020, defying a still uncertain outlook on the COVID-19 pandemic and economy. Investors may ask: Is this a sustainable recovery, or a bubble that may burst? Our model of a market-implied U.S. equity risk premium (ERP) suggests that high prices are largely explained by historically low real rates, and valuations are consistent with a modestly recessionary economic outlook.
Is the Market Recovery Sustainable?
As traditional valuation ratios — such as the cyclically adjusted price-to-earnings ratio, or CAPE — approach levels unseen since the dot-com bubble, investors may question whether the equity market’s recovery is sustainable. We turn to our model-implied, forward-looking ERP to compare current prices to historical valuations.
The model relates market prices to expected future cash flows and discount rates to produce a valuation measure for equity similar to a spread for a bond: A higher ERP corresponds to lower prices and higher expected returns. Like the CAPE ratio, our model-implied ERP evaluates current equity prices relative to long-term earnings, but goes further to account for economic growth and changing real rates, allowing for comparison across macro regimes.1
We find that at current valuation levels, the implied ERP is well above its average over the last three decades, and is similar to that of the last decade. While CAPE suggests that the market has a similar valuation to that at the height of the dot-com bubble, the model-implied ERP is not nearly as compressed as 20 years ago. Historically low real interest rates are the key difference.
The risk premium, however, is only one part of the equation. As a persistent low-yield environment may loom,2 the model-implied total expected annual return for a 10-year horizon is 5.4%, much lower than the total realized annual return of 13.5% of the 2010s.3
Model-Implied US Equity Risk Premium Is Similar to Historical Averages
The model-implied U.S. equity risk premium (ERP) for a 10-year horizon (dark blue line) provides a view of equity valuations, with higher ERP corresponding to lower prices. It bears similarity to the inverse of the cyclically adjusted price-to-earnings ratio (CAPE) (yellow line), but it corrects for economic growth and changing real rates. Ten-year real rates (light blue line) were at historical lows, as of Sept. 30, 2020, at -1.0%. In historical context, the current model-implied ERP is similar to its average level in the past decade, and is not nearly as compressed as during other bull-market periods such as the dot-com bubble. Given the low-yield environment, however, the model-implied total expected return of U.S. equity is lower than that of the 2010s.
How to Explain the US Equity Rebound?
In March, we explored a range of macroeconomic scenarios that the market could have been pricing in. We showed that even under a “Lasting Recession” scenario similar to what followed the 2008 global financial crisis — which assumes a -5% short-term growth shock and -0.5% long-term growth shock to the pre-crisis baseline — the market had priced in a sharp increase in risk premia of nearly three percentage points.
Of the -34% total return of the MSCI USA Index from its Feb. 19 peak to March 23 trough, the “Lasting Recession” scenario attributed the largest contribution, -30.5%, to a rising ERP. Meanwhile, the decline in real interest rates during that period provided a modest, offsetting contribution of 7.4%, seen in the upper bar in the exhibit below. This implied that if risk premia subsided to more normal levels, there was room for significant price recovery.
Six months later, that price recovery has taken place. We consider the same recessionary scenario as of Sept. 30, when the Index was slightly above its Feb. 19 baseline with a 0.9% real price return. Our analysis (lower bar in the exhibit below) shows that the further decline of the real interest rate — driven in part by strong monetary policy by the Federal Reserve — has boosted the valuation by over 10.1% compared to the Feb. 19 baseline. Under the same recessionary assumptions on both long-term and short-term growth rates, the model-implied risk premia have fully recovered to the pre-COVID-crisis level, contributing a positive 3.6% to the valuation.
While price-to-earnings ratios and booming tech companies might seem reminiscent of the late 1990s, our model suggests we're in a new era of high prices and low expected returns.
Model-Implied Risk Premia Have Fully Recovered to Pre-COVID Levels
Using our macro-finance model, we attribute the total U.S. equity returns (as measured by the MSCI USA Index) from Feb. 19 to March 23 (upper bar) and from Feb. 19 to Sept. 30 (lower bar), indicated by blue dots, to shocks of various macro variables. Real-rates shock reflects the actual real yield curve’s change during each period; short-term and long-term growth shocks are assumed to be -5% and -0.5%, respectively, under the “Lasting Recession” scenario; and the ERP shock is implied from the equity-price changes in each period. Propped up by historically low real rates, U.S. equity valuations are consistent with a moderate-recession scenario, while the model-implied risk premium has recovered to its pre-COVID level.
The author thanks Peter Shepard and Andrea Amato for their contributions to this blog post.
1Our model connects equity prices with macroeconomic variables through a discounted-cash-flow model. It is similar to a Gordon Model, in which 
2Timiraos, N. “Fed Signals Low Rates Likely to Last Several Years.” Wall Street Journal, Sept. 16, 2020.
3Total expected annual return is defined as model-implied ERP plus expected return of nominal Treasury bonds.