Mike hammer
Both events were truly terrifying for investors but both also proved to be great buying opportunities. At the market’s low in 2020, the ERP reached nearly 700bp, a level we have surpassed only two other times in the past 30 years – during the global financial crisis in 2008 and in summer 2011, when US Treasury debt was downgraded. For example, in March 2020, valuations collapsed as equity markets panicked about what the lockdowns and recession would do to growth and earnings. At that point, the P/E was 16x, right in line with our de-rating forecast for this year but above our current fair value multiple of 14.6x, which assumes an ERP of 370bp and a 10-year Treasury yield of 3.15%.Īs noted above, predicting the right multiple for stocks may be one of the hardest things to do as an investor however, there are times when the valuation gets so out of line the call is easier to make. At the lows just a few weeks ago, the P/E was down close to 24% when the index was down 20%. To illustrate this point, the S&P 500 P/E has fallen approximately 20% while the price has fallen only 15%.
Mike hammer driver#
Year to date, the biggest driver of stocks has been the de-rating in valuations. The equity risk premium is therefore just a plug based on those independent variables, making it relatively volatile. At any given time, the P/E ratio and 10-year Treasury yields are observable from market prices. There are just two components – 10-year Treasury yields and the equity risk premium (ERP). Our methodology is fairly simple, which doesn’t make it right but does make it easy to determine what kind of bet one is making.
For equity strategists, predicting valuations is core to the job and so we spend a lot of time on it. This is probably because it’s hard to do consistently and there are so many methodologies it’s often difficult to know if you are using the right one. In my experience, most investors don’t spend nearly as much time trying to predict multiples as they do earnings. However, they are far from stable and often hard to predict. Over time, the lion’s share of stock returns is determined by earnings growth if one assumes that valuations are relatively stable.