Equity Risk Premium in US market

Equity Risk Premium (ERP) refers to the additional return over risk-free interest rate for holding equity. 

ERP can be computed by taking earnings yield (inverse of P/E ratio) minus risk-free rate. 

Current Fed rate and Current PE ratio

Risk-free rate = Current Fed rate = 5.25-5.5%. Let's take 5.25%.

Current S&P P/E ratio = 27 (it's around 27-28. Let's take 27).

S&P earnings yield = 1/27= 3.7%.

ERP = 3.7% - 5.25% = -1.55%

Current Fed rate and Forward PE ratio

Risk-free rate = 5.25%.

Forward S&P P/E ratio = 23

S&P earnings yield = 1/23 = ~ 4.35% 

ERP = 4.35% - 5.25% = -0.9%

Forward Fed rate and Forward PE ratio

Forward Risk-free rate = 4.25% (assuming 4 Fed cut by end 2024)

Forward S&P P/E ratio = 23

S&P earnings yield = 1/23 = ~ 4.35% 

ERP = 4.35% - 4.25% = 0.1%

So, the ERP for US equities is either negative or flat. This implies that investors are very confident on the US market that they require no additional return over risk-free rate to hold US equities. If ERP is negative, investors are 'paying' to hold US equities. 

In short, US equity market seems overvalued, based on ERP. 

(Of course, S&P can still have good returns in 2024, if the sentiment for US market is very good or Fed rate will have more than 4 cuts. I do not know how markets will perform in the future. )

S-Reits and what if higher-for-longer interest rate persist

Based on InvestingNote's tracking, out of 44 S-Reits / Biz-Trust, more than half (or 26) reported lower DPU (dividend per unit) compared to the previous year's.  

The lower DPUs can be partly (or mainly) attributed to high interest rate environment. 

What if US Fed does not cut interest rate or the cut is smaller than expected, and the interest rate continue to hold at around 4% level. 

- First, S-Reits' DPU may continue to suffer, as many S-Reits may hedge their interest cost earlier and have not borne the full blunt of the higher interest rate. Hence, when they need to re-finance their loan, they need to incur higher interest cost and lower DPU.

- Second, Singapore (and Hong Kong) properties tend to have low capitalisation rate (cap rate). If the higher for longer environment persist, say, 5 years, the cap rate may become higher and hence lower the valuation (or NAV) of the properties undering S-Reit. Lower valuation will lead to higher leverage ratio (as borrowings remain unchanged). If leverage ratio gets too high (e.g. 45% or more), the S-Reit will be in trouble. 

I do not know how US interest rate will unfold moving forward. But I will keep my reits positions small. 

14 Mar update: IFAST has a good article in Nov 2023 on how high interest rates may affect S-Reits  in near future.  https://secure.fundsupermart.com/fsmone/article/rcms282441/be-selective-in-s-reits-as-rates-stay-higher-for-longer