about 1 year ago • 1 min
The equity risk premium (ERP) is the difference between the consensus earnings yield (earnings divided by share price) and the risk-free rate (the yield on the US 10-year Treasury). It is the added compensation an investor could receive, over and above a risk-free asset such as a government bond, for taking on the extra risk of investing in stocks. And it’s a good measure of how cheap (or expensive) stocks are.
As you probably know, equities have always provided better returns than bonds over the long run, but they’ve also come with more excitement on the risk front. Right now the ERP (blue line) is below 250 basis points – or 2.5% – the lowest it’s been since 2014. And that means investors shouldn’t expect too much reward for their risk. Look at it this way: over the long run, the ERP has sat at an average of 4.5%. But S&P 500 earnings would have to grow by nearly 7% for the premium to hit that figure now – and given the forecasts of economic recession and cost pressures from tight labor markets, that seems pretty unlikely.
Now, the ERP does tend to increase during recessions and rising unemployment. And what that suggests is there could be a fall ahead for share prices to achieve that extra compensation over US Treasuries. In other words, stocks are looking a bit rich now and may need to get cheaper. This is another potential warning signal for equities as we get closer to 2023. The best buying opportunities tend to be when the ERP shoots above 4.5% – that’s when you might want to become more aggressive. Below 2.5%, on the other hand, warrants caution.
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