Investors’ concept of risk has been totally distorted

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Heading into 2025, this question must be addressed: What is a razor-thin equity risk premium (ERP) telling us?

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Investors willingly investing in the market today, in this environment, can only rationally be doing so if they are in it for the long run, never to sell under any circumstances. If that is your belief, then go right ahead. This is your sort of market.

But if you believe that the ERP should be positive or anywhere close to the long-run mean of 300 or 400 basis points, then, arithmetically, only three things can happen: interest rates have to come down, the equity market will have to come down or some combination thereof.

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The valuations in the S&P 500 are such that 20 per cent average annualized earnings growth is now being embedded in the pricing of the index. That is nearly triple the historical norm over half-decade cycles based on a century of data.

I know there are folks out there who believe 20 per cent average annual profits growth is doable — even though it is a one-in-20 event historically speaking (it did happen in the mid-to-late 1990s) — and who believe that the ERP is appropriate.

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Again, to believe that is to believe there will never be any sellers. That is what equity portfolio managers also believe because they are running their funds with barely more than one per cent cash ratios, which is unheard of in the annals of financial history.

Because I believe that earnings growth estimates are too lofty, even with the artificial intelligence (AI) craze and how it will change the world, and because I believe the ERP should be above zero (as risky assets should command a risk premium against riskless assets), I am still largely on the sidelines.

There’s the rub. If you believe it is appropriate that the ERP is zero, or close to zero, then you must believe, in the name of logic and consistency, that the S&P 500 has emerged as a “riskless asset” — treating it as one would a Treasury bill in terms of capital risk — and that the constituents in the index collectively have become zero-beta stocks. Sorry, but I am not there. There is new-era thinking and then there is wishful thinking.

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I also believe that by the time the top is turned in, there will be a mad scramble to get out because the two extreme primal emotions of investing — fear and greed — never go out of style. Greed has been working and may continue to work in 2025, but as American economist Herbert Stein famously said, “If something can’t go on forever, it will stop.”

The problem is that because there is so much overexposure to equities on household balance sheets, everyone is going to be trying to bail out together with precious few buyers on the other side, because there aren’t exactly a whole lot of folks out there with a cash position like mine (oh, save for Warren Buffett … the two of us will be there, rest assured, to be the providers of liquidity when the time comes).

I don’t know when that time will be, but I do know it will come. And as we saw with the internet, the impact of AI will exert a powerful influence on our lives, both personally and professionally.

But the stock market will be on a different plane as investors confront a landscape where multiples contract, as they always do once the cycle shifts to a new chapter, when there is no more good news to be priced in since it has already been fully incorporated (and at peaks, more than fully priced in).

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As was the case with the internet in the mid-to-late 1990s, AI has supercharged the stock market, and the capex surge is becoming increasingly evident with mega expansion spending into data centres and specialized microchips.

JPMorgan Chase & Co. estimates that capital spending and research by just the Magnificent Seven will be US$500 billion in the next year, with a total corporate AI spend of more than US$1 trillion in the United States — that’s bigger than the United States defence budget.

At issue, which we see time and again when the technology curve hits an inflection point, investors see the capex boom (R&D spending is definitely booming) and then anticipate fat returns from this capital deployment.

The problem is when investors start to over-anticipate. That is the real question: where are we in this cycle?

We know what happened when the gig was up in the winter of 2000, but is this 1996? 1997? 1998? 1999? The internet bull market that morphed into a mania and then into a huge bubble began in the summer of 1995, but the party went on for nearly five years.

To reiterate, an ERP at or near zero is a sign that investors in today’s world are willing to treat equities as a riskless asset — no different than T-bills. Except for the simple reality that T-bills carry no capital risk at all. Equities do. This is the extent to which the equity market has become a true believer in the phrase “It is different this time.”

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This also happened in the mid-to-late 1990s. A similar phenomenon exists today in the bond market, where investors are treating investment-grade corporate bonds as if they are Ginnie Mae mortgage bonds, except that one has a historic default rate of 1.5 per cent and the other is zero per cent.

In other words, the concept of risk has been totally turned on its head these past 18 months. We are living through a rare period in financial history. But these cycles don’t tend to end very well. More like in tears.

I am still not participating, but I do recognize that all exponentially rising markets go further than we think, and this one is no different than others in the past. But because they do not correct by moving sideways, and I can’t possibly know when this mania will end (let’s call it a mania going forward, not a bubble, because only a fool would say this is not a mania), I am still largely (not at all totally) on the sidelines.

As I said, when everyone ends up heading for the exits when this cycle ends and finds out there are few buyers on the other side, things will turn very ugly.

My biggest concern is the undue 70 per cent concentration of equities on U.S. household balance sheets (roughly 10 per cent are in bonds). Retail investor flows into passive indexed equity funds are off the charts; this blind investing is now fast approaching 60 per cent of the entire stock market capitalization.

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Institutional investors are sitting on record low liquidity ratios of barely more than one per cent — think of what that means if client redemption ever does resurface. And they always resurface because fear and greed are part and parcel of the cycle at extremes … these primal emotions never go away, and we have to add that the equity market is, after all, an asset class that is speculative by its very nature.

I am still very much in low-risk/low-beta/low-cyclicality mode and primarily interested in the preservation of capital and cash flows. Nothing wrong from my end with a barbell of 4.5 per cent yielding T-bills and 5.5 per cent yielding government-guaranteed mortgage bonds. Municipal bonds with an effective after-tax yield of six per cent-plus also deserve a look. And then throw in gold, which remains in a full-fledged bull market whose tailwinds remain fully intact. Safe and sound.

The bottom line: We are in this strange backdrop where investors believe there is no recession risk, no risk of earnings disappointments, no risk of equity selling by anyone and zero risk of any credit defaults. We are in a once-in-a-lifetime situation where the concept of risk has been totally distorted: an investment world where there is no more differentiation between what has traditionally been risky and what is riskless.

David Rosenberg is founder and president of independent research firm Rosenberg Research & Associates Inc. To receive more of David Rosenberg’s insights and analysis, you can sign up for a complimentary, one-month trial on the Rosenberg Research website.

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