Heading into 2025, the question must be addressed: What is a razor-thin equity risk premium (ERP) telling us?
Investors willingly investing in the market today in this environment, to repeat, can only rationally be doing so if they are in it for the long run; never to sell under any circumstances.
If that is your belief, then go right ahead. This is your sort of market.
But if you believe that the ERP should be positive or anywhere close to the long-run mean of 300 or 400 basis points, then arithmetically, only three things can happen: interest rates have to come down, the equity market will have to come down, or some combination thereof. (I calculate the ERP as the excess return that investing in the S&P 500 provides over risk-free U.S. T-bills).
The valuations in the S&P 500 are such that 20 per cent average annualized earnings growth are now being embedded in the pricing of the index – that is nearly triple the historical norm over half-decade cycles based on a century of data. I know there are folks out there who believe 20 per cent average annual profits growth is doable (it did happen in the mid-to-late 1990s) – even though it is a 1-in-20 event historically speaking – and who believe that the ERP is appropriate.
Again, to believe that is to believe there will never be any sellers. That is what equity portfolio managers also believe, because they are running their funds with barely more than 1 per cent cash ratios, unheard of in the annals of financial history.
Because I believe that earnings growth estimates are too lofty, even with the AI craze and how it will change the world, and because I believe that the ERP should be above zero (as risky assets should command a risk premium against riskless assets), I am still largely on the sidelines. There’s the rub. If you believe that it is appropriate that the ERP is zero, or close to zero, then you must believe, in the name of logic and consistency, that the S&P 500 has emerged as a “riskless asset” – treating it as one would a Treasury bill in terms of capital risk – and that the constituents in the index collectively have become zero-beta stocks.
Sorry, but I am not there. There is new-era thinking and then there is wishful thinking.
And I also believe that by the time the top is turned in, there will be a mad scramble to get out because the two extreme primal emotions of investing, fear and greed, never go out of style. Greed has been working, and may continue to work in 2025, but nothing lasts forever.
The problem is that because there is so much overexposure to equities on household balance sheets, everyone is going to be trying to bail out together with precious few buyers on the other side, because there aren’t exactly a whole lot of folks out there with a cash position like mine. (Oh, save for Warren Buffett. The two of us will be there, rest assured, to the providers of liquidity when the time comes.)
I don’t know when that time will be, but I do know it will come. And as we saw with the internet, the impact on AI will exert a powerful influence on our lives, both personally and professionally, but the stock market will be on a different plane as investors confront a landscape where multiples contract, as they always do once the cycle shifts to a new chapter when there is no more good news to be priced in since it had already been fully incorporated (and at peaks, more than fully priced in).
As was the case with the internet in the mid to late 1990s, artificial intelligence has supercharged the stock market, and the capex surge is becoming increasingly evident with mega expansion spending into data centres and specialized microchips. JPMorgan estimates that capital spending and research by just the Magnificent Seven will be US$500-billion in the next year, with a total corporate AI spend of more than $1-trillion in the U.S., bigger than the defence budget.
At issue, which we see time and again when the technology curve hits an inflection point, investors see the capex boom (R&D is definitely booming) and then anticipate fat returns from this capital deployment.
The issue is when investors start to overanticipate. That is the real question – where are we in this cycle? We know what happened when the gig was up in the winter of 2000, but is this 1996? 1997? 1998? 1999? The internet bull market that morphed into a mania and then into a huge bubble began in the summer of 1995, but the party went on for nearly five years.
I am still not participating but do recognize that all exponentially rising markets go further than we think, and this one is no different than the others in the past. But because they do not correct by moving sideways, and I can’t possibly know when this mania will end (let’s call it a mania going forward, not a bubble, because only a fool would say this is not a mania), I am still largely (not at all totally) on the sidelines.
As I said, when everyone ends up heading for the exits when this cycle ends, and finds out there are few buyers on the other side, things can turn very ugly, and my biggest dilemma is the undue 70-per-cent concentration of equities on household balance sheets (less than 10 per cent are in bonds). Retail investor flows into passive indexed equity funds are off the charts – this blind investing is now fast approaching 60 per cent of the entire stock market capitalization. And the fact that institutional investors are sitting on record low liquidity ratios of barely more than 1 per cent – think of what that means if client redemptions ever do resurface. And they always resurface because fear and greed are part and parcel of the cycle at extremes. These primal emotions never go away, and we have to add that the equity market is, after all, an asset class that is speculative by its very nature.
I am still very much in low-risk/low-beta/low-cyclicality mode and interested primarily in the preservation of capital and cash flows. Several weeks ago, I advocated reducing long-duration exposure in bonds, but that was before the pieces were being put together regarding president-elect Donald Trump’s economics team. Specifically, I am less nervous about a tariff war now than I was before. That said, I myself have not moved out of the core cash position.
Nothing wrong from my end with a barbell of 4.5 per cent yielding T-bills and 5.5 per cent yielding government-guaranteed mortgage bonds. Safe and sound.
David Rosenberg is founder of Rosenberg Research
Earlier columns from David Rosenberg:
My epiphany - and why this bull market may not be as irrational as I had thought
How investors should position themselves for 2025, a year riddled with uncertainty
It’s time for a broad move into cash. Even most bonds and commodities have become too risky