David Rosenberg: Investors' concept of risk has been totally distorted and not for the better

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Risk, profit and loss in investment concept, small white cube block with alphabet building the crossword word mainly as Profit with the word Loss and Risk on financial investment reports
We are in a once-in-a-lifetime situation: an investment world where there is no more differentiation between what has traditionally been risky and what is riskless. (Credit: Nuthawut Somsuk/Getty Images iStockphoto files)

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

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.

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.

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.

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).