Risk premiums, earnings, & multiples

by Wayne Ferbert on September 11th, 2013

I discovered a blog this week that really does an excellent job at writing instructive posts. The blog is called Humble Student of the Markets and it is hosted at BlogSpot. The URL is humblestudentofthemarkets.blogspot.com.
If you read his post from Sunday September 8th, he leads with the concept that the taper will be bad for equity markets. This isn’t a new concept and we have been discussing it on this blog for sometime. However, the way he explains it is very insightful.
We have been pointing out that when the Fed pulls back, the buyers of fixed income that the Fed displaced will move back in to that space. This should mostly look like a rotation from equity to bonds -- or, as the guys on TV like to say: from risk assets to income assets.
But the author at Humble Student points out that this is the same as saying that the risk premium will need to go up to keep those investors in place. The fixed income investors have been willing to accept a lower risk premium for being in equity markets – mostly because their presence there was a result of a displacement by the Fed (ie, the artificial driving down of interest rates).
Now that the Fed will be pulling back, the risk premium that the investor wants to collect has to go up. For the risk premium to go up in the equity markets, the price of equities has to go down. Which means the stock multiples have to come down.
A company makes earnings and you pay a price for that earnings that is a multiple of the earnings. The earnings per share divided by the price per share is the return the stock produces. That is mathematically the same as 1 divided by its multiple. If you require a higher return than you did before, than the price has to go down – ie, the multiple has to go down.
So, the Fed taper is destined to drive up the risk premium – and put real pressure on the equity market multiples. The other part of the equation is the earnings themselves. If they can improve, then maybe the equity markets can justify their values.
Can earnings improve? Sure but the chart on the site that I found most interesting is below. It is a chart of the earnings growth in the S&P500 both with and without financial stocks. And you can see the trend is worrisome. Growth in earnings outside of financial stocks is flattening significantly. 

An improving economy should see better growth numbers in the other sectors. Participation in earnings improvement should be more wide spread. And since the growth ex-financials is sloping downward, it can concern you that the trend could continue downward and become negative.
Earnings can be difficult to predict. And believe me, the financials have more room to grow earnings as interest rates rise. However, can they make up for all of the other sectors flat lining? It certainly calls in to question the health of the overall economy when the financial services sector is driving all of the net earnings growth.

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