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Category: Equity Risk Premiums

Data Update 2 for 2023: A Rocky Year for Equities!

by Aswath Damodaran

It is the nature of stocks that you have good years and bad ones, and much as we like to forget about the latter during market booms, they recur at regular intervals, if for no other reason than to remind us that risk is not an abstraction, and that stocks don't always win, even in the long term. In 2022, we needed that reminder more than ever before, especially after markets came roaring back from the COVID drop in 2020 and 2021. While there are many events during 2022, some political and some economic, that one can point to as the reason for poor stock returns, it is undeniable that inflation was the driving force behind the market correction. In this post, I will begin by chronicling the damage done to equities during 2022, before putting the year in historical context, and then examine how developments during the year have affected expectations for the future. I will follow up by looking at the mechanics that connect stock prices to inflation, and examine why the damage from higher inflation can vary across companies and sectors. 

Stocks: The What?

We invest in equities expecting to earn more than we can make on risk free or guaranteed investments, but the risk in equities is that actual returns can deviate from expectations. In some years, those deviations work to our benefit and in others, it can hurt us, and 2022, unfortunately, fell into the latter column. In this section, I will begin with a (Read more...)

Reaping the Whirlwind: A September 2022 Inflation Update!

by Aswath Damodaran

In my early 2021 posts on inflation, I argued that while the higher inflation that we were just starting to see could be explained by COVID and supply chain issues, prudence on the part of policy makers required that it be taken as a long term threat and dealt with quickly. Not only did they not do so, but the fiscal and monetary actions they took in 2021 exacerbated inflationary pressures. By the start of 2022, the window for early action had closed and for much of this year, inflation has been the elephant in the room, driving markets and forcing central banks to be reactive, and its presence has already induced me to write three posts on its impact. In my first on May 6, 2022, I put the surge in inflation, in 2022, in historical context and argued that it is unexpected inflation that shakes up the economy and caused damage to financial assets, and that until we reached a steady state, where expectations and actual inflation converge, markets would continue to be unsettled. In a follow-up post on May 20, I looked at the disparate effects of inflation on individual companies, positing that safer companies with pricing power are more protected against inflation than riskier companies in competitive businesses. In a third post on July 1, 2022, I pointed to inflation as a key culprit in the retreat of risk capital, i.e., capital invested in the riskiest segments of every market, and presented evidence (Read more...)

Country Risk: A 2022 Mid-year Update!

by Aswath Damodaran

It has been my practice for the last two decades to take a detailed look at how risk varies across countries,  once at the start of the year and once mid-year. In most years, the differences between the two updates are small, and often ignorable, but this year's update brings significant changes for many reasons. The first is the retreat of risk capital, which I talked about in my last post, not only affects the flow of capital and repricing of the riskiest assets (high yield bonds, money losing companies) within each asset class, but also has consequences for the flow of capital across geographies, with riskier countries feeling the effect more than safer countries. The second is that this has been a consequential year for country risk shifts, with Russia's invasion of Ukraine upending risk not only for those countries, but also in the region, and tumult in Sri Lanka and Pakistan playing out as risk to investors in both countries.

Country Risk: Drivers and Measures

    An investment in Nigeria or Turkey clearly exposes a firm or investor to more risks than an otherwise similar investment in Germany or Canada, but why? Some of the differences can be traced to the stability  and growth prospects of the underlying economies, some to political and legal structures and some to geography.  Rather than provide a laundry list, I attempted to summarize the four key drivers of country risk differences in the table below:

Let’s start with political structure, (Read more...)

Risk Capital and Markets: A Temporary Retreat or Long Term Pull Back?

by Aswath Damodaran

As inflation has taken center stage, markets have gone into retreat globally, and across asset classes. In 2022, as bond rates have risen, stock prices have fallen, and crypto has imploded, even true believers are questioning what the bottom for markets might be, and when we will get there. While it is easy to call the market movement in 2022 a correction and to argue that it is overdue, it is facile, and it fails to address the question of why it is happening now, and whether the correction is overdone or has more to go. In this post, I will argue that almost everything that we are observing in markets, across asset classes, can be explained by a pull back on risk capital, and that understanding the magnitude of the pull back, and putting in historical perspective, is key to gauging what is coming next.

Risk Capital: What is it?

To put risk capital in perspective, it is best to start with a definition of risk that is comprehensive and all-inclusive, and that is to think of risk as a combination of danger (downside) and opportunity (upside) and to consider how investments vary in terms of exposure to both. In every asset class, there is a range of investment choices, with some being safer (or even guaranteed) and others being riskier.

Risk capital is the portion of capital that is invested in the riskiest segments of each market and safety capital is that portion that finds its way to (Read more...)

Data Update 2 for 2022: US Stocks kept winning in 2021, but…

by Aswath Damodaran

Leading into 2021, the big questions facing investors were about how quickly economies would recover from COVID, with the assumption that the virus would fade during the year, and the pressures that the resulting growth would put on inflation. In a post at the start of 2021, I argued that while stocks entered the year at elevated levels, especially on historic metrics (such as PE ratios), they were priced to deliver reasonable returns, relative to very low risk free rates (with the treasury bond rate at 0.93% at the start of 2021). At the start of 2022, it feels like Groundhog Day, with the same questions about economic growth and inflation looming for the year, and the same judgment about stocks, i.e., that they look expensive. In this post, I will begin with a historical assessment of stock returns in the recent past, then move on to evaluate the returns that investors can expect to make, given how they are priced at the start of 2022, and end with a do-it-yourself valuation of the index right now.

The year that was.... 

    If equity markets surprised us with their resilience in 2020, not just weathering a pandemic for the ages, but prospering in its midst, US equity markets, in particular, managed to find light even in the darkest news stories, and continued their rise through 2021. Foreign markets, though, had a mixed year, and that divergence is worth noting, since it may provide clues to what may be (Read more...)

Data Update 2 for 2021: The Price of Risk!

by Aswath Damodaran

Investors are constantly in search of a single metric that will tell them whether a market is under or over valued, and consequently whether they should buying or selling holdings in that market. With equities, the metric that has been in use the longest is the PE ratio, modified in recent years to the CAPE, where earnings are normalized (by averaging over time) and sometimes adjusted for inflation. That metric, though, has been signaling that stocks are over valued for most of the last decade, a ten-year period when stocks delivered blockbuster returns. The failures of the signal have been variously attributed to low interest rates, accounting mis-measurement of earnings (especially at tech companies), and by some, to animal spirits.  In this post, I offer an alternative, albeit a more complicated, metric that I believe offers not only a more comprehensive measure of pricing, but also operates as a barometer of the ups and downs in the market.

The Price of Risk

The price of risk is what investors demand as a premium, an extra return over and above what they can make on a guaranteed investment (risk free), to invest in a risky asset. Note that this price is set by demand and supply and will reflect everything that investors collectively believe, hope for, and fear.

Does the price of risk have to be positive? The answer depends on whether human beings are risk averse or not. If they are, the price of risk will be reflected in a (Read more...)

Data Update 2 for 2021: The Price of Risk!

by Aswath Damodaran

Investors are constantly in search of a single metric that will tell them whether a market is under or over valued, and consequently whether they should buying or selling holdings in that market. With equities, the metric that has been in use the longest is the PE ratio, modified in recent years to the CAPE, where earnings are normalized (by averaging over time) and sometimes adjusted for inflation. That metric, though, has been signaling that stocks are over valued for most of the last decade, a ten-year period when stocks delivered blockbuster returns. The failures of the signal have been variously attributed to low interest rates, accounting mis-measurement of earnings (especially at tech companies), and by some, to animal spirits.  In this post, I offer an alternative, albeit a more complicated, metric that I believe offers not only a more comprehensive measure of pricing, but also operates as a barometer of the ups and downs in the market.

The Price of Risk

The price of risk is what investors demand as a premium, an extra return over and above what they can make on a guaranteed investment (risk free), to invest in a risky asset. Note that this price is set by demand and supply and will reflect everything that investors collectively believe, hope for, and fear.

Does the price of risk have to be positive? The answer depends on whether human beings are risk averse or not. If they are, the price of risk will be reflected in a (Read more...)

A Viral Market Update VII: Mayhem with Multiples

by Aswath Damodaran

I get a sense that I am approaching the end of this series of weekly posts, or perhaps I am just hoping that it is true, as the COVID crisis continued to play out in markets in the last two weeks, albeit on a more subdued scale and with a more positive twist. In this post, I will, as in the prior weeks, update the prior weeks’ market action (for two weeks, from April 4 to April 17) in different asset classes, and within equities, across regions, sectors and stock classifications. I will close this post by looking at how pricing tools, including a range of multiples (from PE ratios to price to book to EV to EBITDA multiples) will become shakier and less reliable in the aftermath of the crisis, and suggest ways in which we can compensate for the uncertainties.

Asset Classes
I started my crisis clock on February 14, reflecting the fact that I am US-based, and markets outside China did not wake up to the crisis until that week. In the weeks since, we have seen volatility rise and equity markets get whipsawed, with much of the pain being dispensed in February and the first three weeks in March. In the last month, equity indices around the world have seen positive returns, and in some cases, very good positive returns, as can be seen in the table below.
Download data
The week of April 10 to April 17 was a benign week, at least in sum, (Read more...)

A Viral Market Update VII: Mayhem with Multiples

by Aswath Damodaran

I get a sense that I am approaching the end of this series of weekly posts, or perhaps I am just hoping that it is true, as the COVID crisis continued to play out in markets in the last two weeks, albeit on a more subdued scale and with a more positive twist. In this post, I will, as in the prior weeks, update the prior weeks’ market action (for two weeks, from April 4 to April 17) in different asset classes, and within equities, across regions, sectors and stock classifications. I will close this post by looking at how pricing tools, including a range of multiples (from PE ratios to price to book to EV to EBITDA multiples) will become shakier and less reliable in the aftermath of the crisis, and suggest ways in which we can compensate for the uncertainties.

Asset Classes
I started my crisis clock on February 14, reflecting the fact that I am US-based, and markets outside China did not wake up to the crisis until that week. In the weeks since, we have seen volatility rise and equity markets get whipsawed, with much of the pain being dispensed in February and the first three weeks in March. In the last month, equity indices around the world have seen positive returns, and in some cases, very good positive returns, as can be seen in the table below.
Download data
The week of April 10 to April 17 was a benign week, at least in sum, (Read more...)

A Viral Market Meltdown VI: The Price of Risk

by Aswath Damodaran

It is a sign of how volatile the last few weeks have been,  that a week like the last one, where index levels move only 2-3% a day, high by historic standards, felt stable. As in prior weeks, I will start this one by looking at how the market action last week played out across asset classes, and within equity, across regions and industries first, but the bulk of this post will be an update on the price of risk, and how it has changed in both bond and stock markets over the last six weeks. In the process, I will compare this six-week periods to the 2008 crisis, which was also global, and shook the faith people had in markets, institutions and companies.

The Markets last week
The market action last week was more muted than it had been in prior weeks, but that is a relative statement, as we still saw big swings in almost every asset class. Using the same sequencing that I have used for the last few weeks, I will start with a  review of equity indices globally:
Download raw data
It was a quiet week for most markets, with the Nikkei and the Sensex being the exceptions, dropping 8,09% and 7.46% respectively. Over the last month, every market has seen double digit negative returns, with Shanghai being the only exception. Moving on to US treasuries, we saw more calm than in prior weeks, with rates staying close to where they were in the previous (Read more...)