MARKET UPDATE [August 2025]

Summary:

• Implied Equity Risk Premium (IERP): As of August 31, 2025, the IERP is estimated at 4.10%, below the historical average (5.36%) and recessionary threshold (6.16%), signaling stretched valuations and lower compensation for equity risk.

• Market Valuation & Buybacks: S&P 500 market cap rose to $54.8T with upward earnings revisions, but growth and payout ratios declined. Rising buybacks alongside falling dividends highlight tax and flexibility advantages but pose risks of capital misallocation and financial vulnerability if conducted at elevated valuations.

• Recession-Based Target: In a downturn scenario with IERP rising to 6.16%, the S&P 500 could decline to 4,275.50, representing significant downside risk from current levels.

A.    Implied Equity Risk Premium

The implied equity risk premium (IERP) represents the excess return investors demand for holding equities instead of risk-free government bonds. As it is not directly observable, the IERP is estimated by discounting expected future cash flows, primarily aggregate dividends and share repurchases. At Baoro Research, we calculate the IERP each month at the market index level, utilizing it as an indicator of valuation conditions, investor sentiment, and consequently, potential market direction. As of August 31, 2025, our estimate for the IERP stands at 4.10%, which remains notably below both the historical average of approximately 5.36% and the recessionary threshold of 6.16%.

B.   Market Valuation

Following the latest market update, the total market capitalization of the S&P 500 rose from $52.152 trillion to $54.765 trillion, indicating an increase of $2 trillion in market capitalization. The 2025 earnings forecast was adjusted to 267.5 from the previous 260 reported last month, and the 2026 earnings forecast was also revised to 303.3 from the prior level of 300. The five-year forward CAGR dropped from 9.20% to 9.04%, and the terminal growth rate fell from 4.23% to 4.21%, following recent shifts in 10-year treasury yields. The payout ratio was also reduced by 1% as lower preliminary dividends outweighed increased buybacks.

At the average equity risk premium of 5.36%, the valuation of the S&P500 index stands at 4923.26 at the latest analysis, revised downward from previous 4990.95.  

Additionally, it is important to note observed trends of increasing share buybacks alongside declining dividend payouts. Many firms have adopted buybacks due to their discretionary flexibility afforded to management, as well as greater tax efficiency (dividends are taxed immediately as income, whereas buybacks are subject to capital gains tax only upon the sale of shares by investors). Furthermore, buybacks can be employed as an instrument to reinforce market confidence in the company’s stock. While share repurchases may offer certain advantages compared to dividends, conducting buybacks at elevated valuation levels—as is currently believed to be the case—can present significant risks. Potential consequences of such actions include:

1.      Misallocation of capital

Buybacks are most value accretive when stocks are undervalued If companies repurchase heavily at inflated valuations, they destroy long term shareholder value by paying too much for their own equity instead of investing in productive growth. This is similar to buying back “high” and then later needing to reissue equity at “low”, which may result in a net loss for various firms.

2.      Vulnerability in downturns

When markets correct, those expensive buybacks leave companies with less cash and as a result more inherent financial leverage, which is especially pronounced if firms have engaged in additional borrowing to fund repurchases. This can inherently increase financial fragility, especially in firms with greater cyclical nature to their business model.

Taking these considerations into account, the following table presents S&P 500 index valuations across a range of key implied equity risk premium (IERP) levels.

S&P500 Value (IERP @ 6.16%)

An IERP of 6.16% is commonly observed during periods of economic downturns, which for value investors can indicate a suitable moment to reintroduce equity risk into portfolios. Should the current market narrative lead to challenging economic conditions, S&P500 valuations suggest prices could decrease to 4275.50, a 51.10% decline from current levels. Despite the extent of this potential overvaluation, this remains the base case model, with the intention to reintroduce equity exposure if such a scenario unfolds.

S&P500 Value (IERP @ 6.93%)

An IERP of 6.93% is typically observed during periods of substantial market decline, such as at the height of the global financial crisis. Should a similar scenario arise, the index could experience further depreciation, with the S&P 500 potentially reaching 3,793.49, which would be a decline of approximately 70.30%. While this extent of price decrease may appear improbable, it remains within the realm of possibility based on historical precedents. For instance, equity markets dropped 89% from peak to trough during the Great Depression (1929 to 1932), while during the dotcom bust and subsequent financial crisis, the Nasdaq Composite fell roughly 78% from its March 2000 high to its October 2002 low. Similarly, the S&P 500 and Dow Jones Industrial Average both declined by approximately 50 to 57% during the 2007 to 2009 financial crisis.

Multiples Lens

Due to variability in the inputs and outputs associated with the IERP model, a multiples-based valuation is also conducted. In this approach, cash flows are represented by the sum of aggregate S&P500 firms’ dividends and buybacks on a trailing twelve-month basis.

Data from our model indicates that the S&P 500 historically has an average price to cash flow ratio of 23.4. The multiples at plus or minus one standard deviation are 28.4 and 18.4, while the values at plus or minus two standard deviations are 33.4 and 13.3. Using the most recent trailing twelve months aggregation of firm dividends and buybacks, the following valuations are derived across these key multiples.

Valuation Summary

C.    Recession Probability

The New York Federal Reserve publishes recession probability estimates based on treasury spreads, particularly the difference between the 10-year bond rate and the 3-month treasury bond yields. According to these measures, the projected recession probability for July 2026 is 28.95%, which is lower than the approximately 70% estimate reported in early 2023 during a period of heightened market inflation concerns.

The probability of a recession is determined by models, which can yield varying results depending on the model used and the weighting of different inputs. According to our implied equity risk premium-based model, the assessment is notably different.

Assuming the implied equity risk premium (IERP) decreases to 3.84% (which represents two standard deviations below the historical average) in an expansionary environment, and conversely increases to 6.16% (two standard deviations above the historical average) in a recessionary scenario, one can assess the probability of a recession by comparing the intrinsic values of the S&P 500 at these respective IERP levels to the current observed index level. According to our models, the market currently assigns an implied probability of recession at 13.91%, which is notably lower than estimates derived from treasury yield spreads. If instead the consensus recession probability of 28.95% is applied alongside our estimated range for the IERP, the resulting “fair value” for the S&P 500 is calculated at 5,991.94.