No bubble here! – Part I

4 mins. to read

Guggenheim Partners’ “Macro View” is written by the firm’s Chief Investment Officer, Scott Minerd. It is an excellent market round-up and is rare in that it offers genuine insight into what guides the decision making of one of the most successful fund managers around. And it’s free to sign up to!

OK so now I’ve got the fawning praise out of the way (and no I haven’t received a PR commission to write this blog) I want to draw attention to Mr Minerd’s latest piece. Building on last week’s theme, that liquidity drowned equity markets could be about to experience a crescendo similar to 1999, this week he’s used the S&P500 Equity Risk Premium as a means of further demonstrating that stocks still have some way to go in their irresistible march higher.

Broadly speaking, the S&P500 Equity Risk Premium is the additional yield equity investors can expect to earn from their investments in stocks compared to so-called “risk free” investments i.e. US Treasuries. Of course, I say “risk-free” because anyone who believes in the long-term viability of this fallacy is going suffer a rude awakening one day. For the time being, they need to enjoy the ride as long as it lasts and perhaps the Equity Risk Premium will give warning when this is nearing its end.

There can be different methods to calculate the S&P500 Equity Risk Premium (do a Google search and you will see). Mr Minerd has chosen to subtract real 10-year Treasury yields (which can be found here) from the current yield on the S&P500 (which will be available here for free in 6 weeks). Below is his chart, borrowed from Guggenheim Partners:

Mr Minerd’s interpretation of this chart is that;

“The equity risk premium, measuring the excess return of equities over a risk-free rate, indicates that U.S. equities have not reached bubble levels. Falling from the extremely cheap level at 10 percent in September 2011, the S&P 500 equity risk premium now sits at 4.4 percent, above the historical average of 2.8 percent. With ongoing economic improvement and continued monetary accommodation from the Federal Reserve, the current bull market in U.S. equities, which started in March 2009, should still have room to run.”

The emphases in bold are mine. On balance, it is hard to disagree with Mr Minerd’s final conclusion that QE-addicted markets still have “room to run”. After Janet Yellen’s comments today, there can be little doubt that if she gets confirmed as Bernanke’s replacement, QE3 is going to continue full pace well into 2014.

However, what about Mr Minerd’s first conclusion? US equities have “not reached bubble levels”? Really?

Technically he is correct that his measurement of the S&P500’s Equity Risk Premium is still above the historical average. Even so, he fails to mention two important points. First, as witnessed in 2008, the Equity Risk Premium is prone to precipitous collapses. The chart looks favourable now, but it wouldn’t take much to shift it into dangerous territory.

This leads to the second point I believe Mr Minerd failed to mention; just how tenuous the current situation is. A fall in the S&P500’s yield (which my colleague, Filipe Costa, believes is on the cards) or a rise in rates could suddenly push the Equity Risk Premium into bubble territory. This risk is best illustrated by the chart below:

Showing a 15 year view of the yield paid on US Treasuries, the two widely reported features of this chart are 1) yields are towards historic lows and 2) yields spiked suddenly as the market anticipated the Fed’s taper.

In this month’s edition of SpreadBet Magazine, I created following table to show how the Federal Reserve has effectively monetised the US deficit over 2013:


Total US Federal Debt

As of January 1st 2013


As of October 1st 2013


Increase in the US Federal Debt




Total amount of Treasuries purchased by the Fed each month under QE3


Total amount of Treasuries purchased by the Fed January 1st 2013 to October 1st 2013



Although the “taper” will not mean “total withdrawal”, the self-inflicted monstrous problem facing policy makers at the Fed is that were QE to be removed, bond yields would rise significantly and corporate earnings would suffer. The S&P’s Equity Risk Premium would collapse and stock prices would have to follow. This is the financial equivalent of gravity at work. As if we needed it, the S&P500’s Equity Risk Premium is further evidence just how distorted markets are thanks to monetary policy.

I don’t know about you Mr Minerd, but that is my idea of a bubble. 

**** To finish, I would like to be fair to Mr Minerd (and I am sure he cares greatly what a lowly blogger has to say about him!!!!). He has made repeated warnings about the precarious state we find ourselves in. His latest analysis is limited to a relatively short term view on equities. He will probably be vindicated and we could well see further strong gains in stock markets, moving into the New Year. But remember, the higher markets rise, the further they will have to fall….

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