The US Equity Risk Premium

Marcus Tuck
Head of Research

8 am 30 September 2020

The 12 month forward PE ratio for the US S&P 500 is 21.3. That is high in historical terms but is it high in the current environment?

Source: Bloomberg, The Super Investor

Over recent years, the US 10-year Treasury bond yield has fallen from over 3% to 0.65% currently, providing a very low risk-free rate.

Source: Bloomberg, The Super Investor

A high forward PE ratio in isolation conveys some information but not as much as when the risk-free rate is incorporated into the valuation measure. The lower the risk-free rate, the higher the PE ratio that can be justified.

That is where an estimate of the equity risk premium (ERP) is useful. The ERP is the premium that equity investors require as compensation for the higher risks inherent in holding equities compared to bonds.

The ERP can be calculated by converting the 12-month forward PE ratio into an earnings yield and subtracting the risk-free rate. Currently, the 12-month, forward-looking earnings yield for the S&P 500 is 4.70% (i.e. 100/21.27) and the risk-free rate is 0.65%. That gives an ERP of 4.05%.

Over the last decade the US ERP has averaged 4.35%. At around 4%, the current ERP shows equities to be a little more expensive than average, but not dangerously overvalued.

Source: Bloomberg, The Super Investor

Valuation is only one factor driving equity markets but it is important to keep an eye on it. If the ERP were to drop more than one standard deviation below the mean (i.e. below 3.3%), it would be reason for caution.

Equity markets can correct in the absence of overvaluation and plentiful liquidity can drive valuations to extremes. On the eve of the GFC in 2007, for example, the ERP fell below 2% – a clear sign that equities were expensive relative to bonds.

For now, monetary and fiscal policies are accommodative, leading economic indicators are rising, the US yield curve is positively sloped out to 30 years, S&P 500 earnings most likely bottomed in the June quarter, cash weightings are neutral, and valuation is close to neutral.

Disclosure: Nil.

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