The equity risk premium (ERP) is just one of many metrics we use to gauge market sentiment, mostly to see if we view things differently and can gain an advantage.
In simple terms, the ERP measures the difference between the expected return from equities and the expected return (or yield) on long-dated Treasuries or other sovereign bonds. Theoretically, that difference, or premium, is the added compensation required to entice a prudent investor to forego the relative safety of bonds and jump into more volatile stocks. Today, according to our reading, investors are demanding a whopping 8.5% premium to take the leap. That is as high as it has been in more than 50 years and is equal to the peak reached during the 2008 financial crisis.
Obviously, this premium is signaling the markets extreme fear of stocks. Thats understandable. Stocks have been unusually volatile and, given todays towering uncertainties, they likely will remain so. And because the ERP equation entails making assumptions about future profitability, it is also telling us that investors are extremely pessimistic about earnings growth and, by association, the economy. But are investors right to be so gloomy?
The answer has obvious investment implications. By dissecting ERP components, my colleague Brian Lomax calculated that the market, assuming fair value, is pricing in compound, annual-earnings growth of roughly 4.5% and average return on equity (ROE) of 8.7% ad infinitum. If this outlook proves to be too grim, then stock prices (and bond yields) should ultimately rise as expectations catch up with reality, driving the ERP lower. A return to the five-year average ERP of 6% implies upside potential of 70% versus bonds, all else being equal (Display). Id say thats quite an inducement to own stocks. But if the earnings outlook implied by the ERP proves closer to the truth, stocks are going nowhere.
So how probable are the expectations that are baked into stock prices? History suggests not very. Since 1946, earnings growth has exceeded 4.5% in two-thirds of rolling five-year periods and has averaged 6.8%. Five-year ROE has never been as low as 8.7% and has averaged 12.6% over the same period. Our sensitivity analysis of S&P 500 earnings similarly concluded that near-term US profitability was more resilient than stock prices reflected, as noted in my recent blog post, Can US Profits Survive a Stalled Economy?
If were right that earnings expectations are overly pessimistic, then the upside potential in equities is extraordinary. And if the market is being too pessimistic about future earnings power in aggregate, probably it is also overlooking important fundamentals that distinguish companies that are likely to thrive in the future from those that will not. Thats when stock pickers gain an edge, especially if they have the research capabilities to spot what the market might be missing.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio teams.
Joseph G. Paul is Chief Investment OfficerNorth American Value Equities at AllianceBernstein.