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?