Equity Risk Premium: Are Stocks Cheap or Dear? - Real Time Insight

By Zacks | June 11, 2012 AAA

By many measures, stocks look cheap. With 2012 EPS estimates for the S&P 500 around $103, the index at 1,320 is currently trading at a P/E under 13X. And based on 2013 top-down estimates near $110, the forward multiple gets juicier at only 12X.

Granted estimates are just that and, a year ago, 2012 projections were also close to that $110 mark but had to come down due to slower-than-expected US growth, the European financial crisis, and the deceleration in China.

There is no doubt that US corporate profits are strong and seem to be holding up in the face of global worries. But is the stock market trading below its mean historical valuation near 15X (during a cyclical expansion) solely because of Europe? (That's a hefty discount of at least 20%).

Or have "lean and mean" profit margins peaked and are estimates due to come down due to pressures both here and abroad?

One way that longer-term investors can get some perspective is to not only look at valuations, but to visualize the "equity risk premium," or ERP for short. It is designed to tell you the excess return you can expect from investing in stocks vs. risk-free bonds.

Since I am neither an economist nor "CFA-trained," take my simple explanation as just that. There are tons of papers debating the theories and methods of calculation that we don't need to bother with for this discussion.

ERP is simply the "earnings yield" of the market minus the risk-free rate.

$103/1,320 = 7.8% minus 1.6% (10-yr yield) = 6.2% ERP

Yes, the ERP is "artificially" high because US government bond yields are so low. But this is still worth talking about because the current low rate regime is still very good for equities both from a economic growth perspective and an investment alternatives perspective.

This graph taken from August 2011, shows how last summer's decline in stocks produced an ERP near historic highs.

At that time, the calculation looked like this...

$95/1,205 = 7.9% minus 2.25% (10-yr yield) = 5.6% ERP

And I said long-term investors should buy stocks and the S&P 500 near 1,100 with both hands because it was an "extreme value area" both fundamentally and technically.

Are we approaching more extreme value?

Or is there more than enough risk to justify this premium and push it even higher (which means stocks go lower)?

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