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Double Dog Dares and Equity Risk Premiums

Back in the day, a double dog dare was often a kid’s first introduction to evaluating risk and reward. The rarely presented double dog dare happens when…

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Back in the day, a double dog dare was often a kid’s first introduction to evaluating risk and reward. The rarely presented double dog dare happens when one kid dares another to do something foolish. Usually, the kid being dared asks for an incentive to complete the challenge.

When assessing a double dog dare, one usually first values the reward. Maybe there are a couple of candy bars or a soda for completing the challenge. Then comes the risk assessment. Does the potential to break an arm or leg exist? Maybe worse, at least in some children’s minds, what will the punishment be for being caught? Simply, is the reward enough to compensate correctly for the risks associated with the double dog dare?

Evaluating the risks and rewards of a double dog dare are not that dissimilar to equity investing, as we explain.

Risk-Free Rates

Investors should expect compensation in the form of capital gains and/or dividends/coupons commensurate with the investment risk. To help evaluate the amount of risk compensation the market is offering, investors need a risk-free return to base the evaluation.

U.S. Treasury securities are a perfect yardstick for this task. They are considered the only risk-free asset in the world. We can debate the merits of their standing all day, but regardless of your opinion, it is a fact in almost all investors’ minds. Further, we can easily find yields for investment terms ranging from next week to 30 years upon which to compare our risky assets.

BAAA

In our article, Goodbye TINA, Hello BAAA, we made the case that expected equity returns for the next ten years are about the same as Treasury bond yields. In the current pricing scenario, the premium paid to stock investors for taking risks is zero. Accordingly, the article makes the case that Bonds Are An Alternative to stocks.  

The graph below from the article shows that five popular methods for calculating equity expected returns range from 4% to -4%. At the same risk-free Treasury yields are near 4%.

Expected stock returns are on par with risk-free Treasury yields but woefully below the premium spread investors should demand. The simple conclusion is that for the entirety of the next ten years, bonds are the better bet.

Equity Risk Premium

In addition to the long-term stock-bond analysis presented in our article, there are other ways to help gauge whether stocks offer an acceptable premium to compensate investors for taking on added risk. One such model and the topic of this article is the equity risk premium. 

The equity risk premium, like the three methods we share in the article, is a valuation-based calculation. However, it tends to rely on shorter-term fundamentals. Essentially our model looks at the expected EPS in one year divided by the current price and compares it to a 1-year forward UST bond yield adjusted for inflation expectations.

The higher the equity risk premium, the more compensation equity investors receive to take on risk.

The graph below charts the S&P 500 equity risk premium using trailing and forward earnings. We offer a special thank you to Kailash Concepts for supplying the equity data for the graph.

equity risk premium

Fair Compensation?

Based on the graph, are equity investors fairly compensated for owning stocks? We can answer the question in a few different ways.

One way is to compare the current risk premium to recent pre-pandemic averages. As shown, outside of a few short-term instances, premiums have not been as low as they are today in 20 years. Further, those instances similar to today occurred after recessions, when the risk of another downturn was minimal, and earnings had significant upside growth potential as the economy recovered. While the premium was lower than average in those instances, the earnings and economic outlook were brighter, possibly justifying a low-risk premium.

Another way to consider the premium is to assess the risk associated with the current financial and economic environment and compare it to the premium. Today, given the potential market turmoil due to a possible recession, higher interest rates, inflation, an aggressively hawkish Fed, and the geopolitical situation in Ukraine, we should be paid more, not less compensation for taking on risk. The other consideration: playing it safe in bonds pays us a comfortable 4% with no risk.

Given the riskier-than-normal outlook and tighter-than-average risk premiums, bonds deserve more attention. BAAA!

How Equity Premiums May Normalize

Three key factors are used to calculate the equity risk premium: earnings, stock prices, and risk-free rates.

For the premium to rise to a more acceptable level, the numerator needs to increase, and/or the denominator falls. In other words, some combination of higher earnings, lower stock prices, and declining yields. We could create a complex table showing the many combinations, but instead, we think it best to focus on the elephant in the room – recession risk.

If we are indeed entering a recession, earnings are likely to fall. The graph below shows that earnings often decline significantly during recessions. If they do fall, the equity risk premium will also drop. Therefore, stock prices must also decline to keep the earnings yield stable.

earnings equity risk premium

However, the onus is not just on earnings and stock prices. If yields fall appreciably, the premium may rise. The bottom line is that all three factors will change. Appreciating what may change and to what degree, given various economic scenarios, will help you better appreciate how and when the equity risk premium may normalize.

Portfolio Management

The model presented above is for the S&P 500. Each stock has its risk premium. While we may not think the market is compensating us properly, many stocks and some sectors have potential earnings growth rates well above market levels with potentially less earnings volatility in a recession.

Portfolio management involves holding stock and bond assets. We believe in active management in which the allocations to stocks and bonds change as their risk-reward calculus changes. Lower risk premiums in a risky environment are leading us today to reduce equity risk.

Summary

“There is no analog. Today’s starting points are like none we have seen. The biggest risk is extrapolating to the future from a past that feels comfortable, confirmed by recent data. Disequilibrium is the new equilibrium.” Erik Peter One River Asset Management

The economic, financial, and geopolitical risks are outsized! Shouldn’t the equity risk premium reflect the situation?  

If we double dog dare you to buy stocks, you should ask for a return that compensates for the additional risk in today’s market environment.

The post Double Dog Dares and Equity Risk Premiums appeared first on RIA.

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New findings on hair loss in men

A receding hairline, a total loss of hair from the crown, and ultimately, the classical horseshoe-shaped pattern of baldness: Previous research into male…

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A receding hairline, a total loss of hair from the crown, and ultimately, the classical horseshoe-shaped pattern of baldness: Previous research into male pattern hair loss, also termed androgenetic alopecia, has implicated multiple common genetic variants. Human geneticists from the University Hospital of Bonn (UKB) and by the Transdisciplinary Research Unit “Life & Health” of the University of Bonn have now performed a systematic investigation of the extent to which rare genetic variants may also contribute to this disorder. For this purpose, they analyzed the genetic sequences of 72,469 male participants from the UK Biobank project. The analyses identified five significantly associated genes, and further corroborated genes implicated in previous research. The results have now been published in the prestigious scientific journal Nature Communications.

Credit: University Hospital Bonn / Katharina Wislsperger

A receding hairline, a total loss of hair from the crown, and ultimately, the classical horseshoe-shaped pattern of baldness: Previous research into male pattern hair loss, also termed androgenetic alopecia, has implicated multiple common genetic variants. Human geneticists from the University Hospital of Bonn (UKB) and by the Transdisciplinary Research Unit “Life & Health” of the University of Bonn have now performed a systematic investigation of the extent to which rare genetic variants may also contribute to this disorder. For this purpose, they analyzed the genetic sequences of 72,469 male participants from the UK Biobank project. The analyses identified five significantly associated genes, and further corroborated genes implicated in previous research. The results have now been published in the prestigious scientific journal Nature Communications.

Male-pattern hair loss is the most common form of hair loss in men, and is largely attributable to hereditary factors. Current treatment options and risk prediction are suboptimal, thus necessitating research into the genetic underpinnings of the condition. To date, studies worldwide have focused primarily on common genetic variants, and have implicated more than 350 genetic loci, in particular the androgen receptor gene, which is located on the maternally inherited X chromosome. In contrast, the contribution to this common condition of rare genetic variants has traditionally been assumed to be low. However, systematic analyses of rare variants have been lacking. “Such analyses are more challenging as they require large cohorts, and the genetic sequences must be captured base by base, e.g., through genome or exome sequencing of affected individuals,” explained first author Sabrina Henne, who is a doctoral student at the Institute of Human Genetics at the UKB and the University of Bonn. The statistical challenge lies in the fact that these rare genetic variants may be carried by very few, or even single, individuals. “That is why we apply gene-based analyses that first collapse variants on the basis of the genes in which they are located,” explained corresponding author PD Dr. Stefanie Heilmann-Heimbach, who is a research group leader at the Institute of Human Genetics at the UKB at the University of Bonn. Among other methods, the Bonn researchers used a type of sequence kernel association test (SKAT), which is a popular method for detecting associations with rare variants, as well as GenRisk, which is a method developed at the Institute of Genomic Statistics and Bioinformatics (IGSB) at the UKB and the University of Bonn.

Possible relevance of rare variants in male-pattern hair loss

The research involved the analysis of genetic sequences from 72,469 male UK Biobank participants. Within this extensive data set, Bonn geneticists, together with researchers from the IGSB and the Center for Human Genetics at the University Hospital Marburg, examined rare gene variants that occur in less than one percent of the population. Using modern bioinformatic and statistical methods, they found associations between male-pattern hair loss and rare genetic variants in the following five genes: EDA2R, WNT10A, HEPH, CEPT1, and EIF3F.

Prior to the analyses, EDA2R and WNT10A were already considered candidate genes, as based on previous analyses of common variants. “Our study provides further evidence that these two genes play a role, and that this occurs through both common and rare variants,” explained Dr. Stefanie Heilmann-Heimbach. Similarly, HEPH is located in a genetic region that has already been implicated by common variants, namely the EDA2R/Androgen receptor, which is a region that has consistently shown the strongest association with male-pattern hair loss in past association studies. “However, HEPH itself has never been considered as a candidate gene. Our study suggests that it may also play a role,” explained Sabrina Henne. “The genes CEPT1 and EIF3F are located in genetic regions that have not yet been associated with male-pattern hair loss. They are thus entirely new candidate genes, and we hypothesize that rare variants within these genes contribute to the genetic predisposition. HEPH, CEPT1, and EIF3F represent highly plausible new candidate genes, given their previously described role in hair development and growth.” Furthermore, the results of the study suggest that genes that are known to cause rare inherited diseases affecting both skin and hair (such as the ectodermal dysplasias) may also play a role in the development of male-pattern hair loss. The researchers hope that the puzzle pieces they have discovered will improve understanding of the causes of hair loss, and thus facilitate reliable risk prediction and improved treatment strategies.

The research was supported by funding from the Medical Faculty of the University of Bonn. Prof. Dr. Markus Nöthen, Director of the Institute of Human Genetics at UKB and co-author of the study, is a member of the Transdisciplinary Research Area (TRA) “Life and Health” at the University of Bonn. The publication costs in open access format were funded by the DEAL project of the University of Bonn.


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Canadian dollar edges higher as retail sales rebound

Canada retail sales climb 2% The Canadian dollar has posted losses on Friday. In the European session, USD/CAD is trading at 1.3446, down 0.28%. Canada’s…

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  • Canada retail sales climb 2%

The Canadian dollar has posted losses on Friday. In the European session, USD/CAD is trading at 1.3446, down 0.28%.

Canada’s retail sales jump

Canada’s retail sales rebounded in impressive fashion on Friday. Retail sales in July jumped 2% y/y, following a -0.6% reading in June and beating the 0.5% consensus estimate. On a monthly basis, retail sales rose 0.3%, up from 0.1% in June but shy of the consensus estimate of 0.4%. The good news was tempered by the August estimate, which stands at -0.3% m/m and would be the first decline since March. The Canadian dollar showed little reaction to the retail sales release.

The Bank of Canada doesn’t meet again until October 25th and policy makers will have plenty of data to monitor in the meantime. The BoC has been walking a tightrope that will be familiar to most central banks, that of trying to balance the risks of over and under-tightening. The difficulty in finding the right balance was highlighted in the BoC summary of deliberations of the policy meeting earlier this month.

The BoC decided to hold the benchmark rate at 5.0% after concluding that earlier rate hikes were having an effect and slowing economic growth. The summary indicated that policy makers were concerned that a pause might send the wrong message that rate cuts might be on the way. With inflation still above the BOC’s target, the central bank is not looking at rate cuts and stressed at the September meeting that rate hikes were still on the table and that inflation remained too high.

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USD/CAD Technical

  • USD/CAD is testing resistance at 1.3468. The next resistance line is 1.3553
  • 1.3408 and 1.3323 are the next support lines

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Quantitative Tightening Is Not Biggest Threat To Global Yields

Quantitative Tightening Is Not Biggest Threat To Global Yields

Authored by Simon White, Bloomberg macro strategist,

The Bank of England’s…

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Quantitative Tightening Is Not Biggest Threat To Global Yields

Authored by Simon White, Bloomberg macro strategist,

The Bank of England’s quantitative tightening program shows that unwinding central-bank bond portfolios, even with outright sales, need not be disruptive for markets. The greater risk for US and global yields comes from positive stock-bond correlations driving risk premia wider.

The BOE has been a pioneer and a thought leader in QT. While the Fed and ECB have only allowed bonds to run off naturally to help achieve their balance-sheet contraction goals, the BOE has sold gilts outright in addition to allowing bonds to mature.

So far, it has not led to any significant market disruption. This enabled the BOE Thursday to increase the pace of reduction in the Asset Purchase Facility (APF) from £80 billion last year to £100 billion over the coming 12 months from October (while holding Bank Rate steady). As colleague Ven Ram also noted, the schedule of maturing bonds next year allowed the bank to keep gilts sales unchanged from last year while increasing the total amount of the APF’s decrease.

The QT watchwords from the bank are “gradual and predictable.” If gilt sales are conducted in such a way, then market disruption should be minimized. The chart below shows the BOE’s own assessment of the impact of bond sales on the market.

The BOE estimates that of the ~40 bps of term-premium increase since the MPC voted to begin QT in February 2022, about 10-15 bps comes from QT specifically – small in comparison to the overall rise in yields since that time.

QT or bond sales, though, are not the most critical risk facing bond prices in the current cycle. Rising and now positive stock-bond correlations threaten to lead to a structural rise in bond risk premium, and lower prices. The correlation is now positive in the US, Japan, and the UK.

In a positive stock-bond correlation world, bonds lose their portfolio-hedge and recession-hedge capabilities, and thus become less sought after. The penny has not fully dropped yet, but the negative term premium for bonds is increasing, and is prone to rising much higher as they become less desirable.

Yields of developed market countries are biased structurally higher, but QT is unlikely to be the culprit. Instead, it allows central banks to reload their capacity for a future time when they may need to restart quantitative easing, in order to stabilize the market from sharply rising term premia.

Tyler Durden Fri, 09/22/2023 - 09:10

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