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.”