by Paul Hoffmeister, Chief Economist
Some of the biggest surprises of the last year have been the multiple expansion we’ve seen in the S&P 500, as well as the dramatic tightening of credit spreads. During the last 12 months (through March 2024), S&P 500 earnings have grown approximately 6.8% while the stock index has rallied nearly 27%. As a result, the S&P’s price-to-earnings ratio has climbed four points from almost 19x to 23x. At the same time, the spread between Moody’s Baa and Aaa-rated bonds has narrowed from approximately 120 basis points to 75 today. This spread shows the difference in what investors demand in compensation for loaning money to companies with moderate credit risk and those with the highest credit quality. Both indicate massive risk appetites among investors today.
This multiple expansion and credit tightening is quite remarkable, historically speaking. Since 1993, the average P/E ratio for the S&P 500 has been 18.7 whereas the tightest that the Baa-Aaa spread tends to get is somewhere between 55 and 75 basis points. Today, stocks are meaningfully more expensive than usual, and credit markets are in a zone typical of some of our best economic periods.
To be sure, the market multiple has been higher in the past and credit spreads have been a little tighter. And, it’s arguably a stretch to say that the market is priced for perfection. But financial markets are pricing in A LOT of optimism. It very well could be that the market believes that Jerome Powell and Co. are successfully threading the needle, by modulating interest rates in almost perfect harmony with the economy. And it could be that investors today are expecting the current Fed pause and possible rate cuts later this year will enable growth to continue or even improve, while at the same allowing inflation to drift lower to the Fed’s 2% target.
What makes today’s “market exuberance” so surprising is the breadth and magnitude of the risks that we see: Ukraine, the Middle East (Hamas, Hezbollah, Iran), commercial real estate, bank challenges, recently higher-than-expected inflation, the federal deficit, and interest costs on the national debt that are about to seemingly explode. Indeed, these risks could subside, and market optimism today could be justified. Notwithstanding, it seems that a lot of things need to go right for risk assets to maintain current price levels and appreciate further.
In the current opportunity set between stocks and bonds, we believe Treasury bonds are more attractive than stocks. Thanks to years of the Fed pushing up Treasury yields and investors recently marking up the value of equities, we face a somewhat unusual situation where the 10-year Treasury is yielding almost what the S&P 500 is yielding.
At a 22.8 P/E ratio, the earnings yield for the S&P 500 is 4.39%. Meanwhile, the 10-year Treasury yield is yielding approximately 4.35%. This means that there is less than 5 basis points in equity risk premium today. The average has been 2.4% since 2000. Today’s low equity risk premium underscores how expensive stocks are today and how little equity investors are being paid to take on equity risk. As we see it, equity investors will need earnings to grow meaningfully in order to generate sizeable returns in the coming years. That’s if, of course, today’s known and unknown risks don’t materialize.
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Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of the Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).
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