On 3 November 2023, Dan Morehead, the Founder and Managing Partner of Pantera Capital, shared a detailed economic forecast that paints a bearish picture for the S&P 500, suggesting a potential fall of 23%. Morehead, who has a history of accurate predictions, referenced his successful forecast from two years prior when he anticipated that both Federal funds rates and the 10-year yield would climb to at least 5.00%—a figure that has now been realized.
Morehead pointed out the current state of wage inflation, which is running at twice the Federal Reserve’s target, and highlighted the ongoing labor strikes as evidence of the economic pressures that necessitate further action from the Fed. He noted the unusual situation where the 10-year note is flat to Fed funds, whereas it typically carries a term premium, historically averaging 1.15% above the cost of funds.
Shifting the focus to stock market valuations, Morehead drew attention to the traditional Price/Earnings (P/E) ratio, which investors have become accustomed to over recent decades, often hovering around 20 times earnings. He offered an alternative perspective by inverting the P/E ratio to yield the earnings yield on equities, which provides a different lens through which to view equity valuations.
According to Morehead, the earnings yield has decreased in line with a general decline in yields across various asset classes, including bonds and real estate. He emphasized that traditionally, investors require an equity risk premium to justify choosing equities over the more certain cash flows of government bonds. However, the long-term rally in yields has, at times, led to an inversion of this relationship.
Morehead recalled that for a significant portion of the 80s and 90s, the earnings yield on stocks was actually lower than that of bonds, a situation that, in retrospect, was justified by the declining rates that fueled equity price returns. Since the mid-2000s, the equity risk premium has returned to positive territory, aligning with historical norms.
He argued that for the last twelve years, equities were relatively inexpensive, with the equity earnings yield often exceeding bond yields by more than 4.00%. However, with bonds now considered to be approximately at fair value, it is equities that appear to be significantly overvalued, with their earnings yield falling below that of treasuries.
Morehead referenced historical data to support his forecast, noting that the 50-year average equity risk premium is +0.27%. If the 10-year treasury yield rises to 5.00% and the earnings yield on equities adjusts to maintain its average spread over treasuries, he anticipates a 23% decrease in equities.
He also outlined a scenario that could be seen as more favorable, albeit still challenging, where equities experience a prolonged period of stagnation, similar to historical periods where stock prices remained flat for roughly 13 years.
In a more severe scenario, should equities adjust to the average equity risk premium observed in similar rising rate environments, which is +2.25% above bond yields, Morehead sees the potential for a 43% decrease in equity prices.
Turning to the implications for blockchain assets, Morehead discussed conversations with asset allocators who are considering investment options in the current climate. He cautioned against investing in bonds, noting the risks in the current environment, and pointed out that real estate is also descending from all-time highs, with equities being overvalued. This leaves room for alternative asset classes, such as real commodities and blockchain assets.
Morehead emphasized the trillion-dollar scale of the blockchain asset class and the negligible exposure most institutions currently have to it. He advocated for institutions to increase their exposure to blockchain assets, suggesting a target of a few percentage points.
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