The Fed & The Equity Risk Premium

While the equity risk premium is currently quite high by historical standards, New York University professor Aswath Damodaran says that might not be an indication that stocks are cheap.

In a post on his “Musings on Markets” blog, Damodaran notes that the equity risk premium (the spread between the risk-free rate and expected stock returns) has historically moved in the same direction as the risk-free rate. From 1960-2003, for example, a 1% increase in the risk-free rate (i.e., the Treasury yield) meant a 0.26% increase in the ERP, he says. That relationship has “dramatically weakened” in the past decade, Damodaran adds. (You can find Damodaran’s monthly ERP calculations here.)

But, if the long-term relationship were to hold up, he says, it could be trouble. “An investor in 2013 is faced with the reality that the U.S. Treasury bond rate does not have much room to get lower and, if mean reversion holds, has plenty of room to move up, and if history holds, it will take the ERP up with it.”  What happens to stocks would then depend on the magnitude of the Treasury bond rate increases and the ERP increase or decrease. He offers a chart showing a myriad of scenarios. For example, he says, “if risk free rates move to 3% and the equity risk premium drops to 5%, the index is undervalued by about 5%.” But, “if rates rise to 4% and the equity risk premium stays at 5.5%, the index is overvalued by 8.28%.”

Overall, Damodaran says he thinks stocks look reasonably priced — compared to other assets. The danger, he says, is that Treasury yields could be artificially low, thanks to the Federal Reserve. If that’s true, he says, we could be in the midst of one or more bubbles, and the ending won’t be a good one.

But while the high ERP doesn’t necessarily mean stocks are cheap, Damodaran says he is “not ready to scale down the equity portion of my portfolio (especially since I have no place to put that money). Looking at the table of market sensitivity to risk free rate/ERP combinations, there are enough soft landing scenarios for the market that I will continue to buy individual stocks, while keeping an eye on the ERP & T.Bond rate.”

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What It Takes To Be A True Value Investor

In a recent CNBC interview, New York University Professor Aswath Damodaran discusses Apple’s valuation, and in the process lays out a great example of what true value investing is. Damodaran says Apple shares are worth $600, about 30% more than their current price, based on his analysis. While the firm’s recent earnings report, which showed low growth and compressed margins, wasn’t great, he says “that would be a problem only if Apple [had been] priced on the basis of the expectation of high growth. … This is a company that’s being priced for no growth and compressed margins already.” He says that part of why the shares haven’t rebounded is that many people who claim to be value investors aren’t really willing to be value investors when times get tough. “If you’re a value investor, a true value investor, you’ve got to invest when you’re not comfortable,” he says. He says he’s not totally comfortable buying Apple right now, but he will because, while others have been focused on Apple’s share price and downward momentum, he’s looking at the firm as a business. “And I think I’m getting a pretty good business for the price I’m paying,” he says.

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Siegel: Stocks Are Cheap

Several top strategists recently spoke at the CFA Institute Equity Research and Valuation Conference, and The Motley Fool’s Bryan Hinmon and Michael Olsen highlighted a few pieces of advice from these gurus.

One was author and Wharton Profesor Jeremy Siegel, who advised that “stocks are cheap”. Siegel said stocks are trading below average historical valuations, and noted that there has never been a 20-year period where real returns on a diversified U.S. stock portfolio have been negative.

Michael Mauboussin, Legg Mason’s Chief Investment Strategist, talked about the importance of figuring out what is already priced into a stock or the market. “Investing, he says, is a game of expectations, and you make money by sticking to situations where you believe the opportunities are greater than what other investors expect,” Hinmon and Olsen write.

In addition to Siegel and Mauboussin, NYU Stern School of Business Professor Aswath Damodaran and top-performing fund manager Preston Athey also offered their insights. To read the full article click here. 

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