Understanding The Equity Risk Premium to Evaluate Investment Opportunities and Strategies
We are currently keeping a close eye on the expected additional returns from holding equities versus bonds…
To break it down, let's first think about buying a bond, which can be thought of as giving a loan. When we do that, we pretty much count on the folks who issued it to pay back our money plus interest (unless they hit a rough patch and end up going bankrupt, which is a type of risk that bond investors must worry about called credit risk). So, assuming the issuer is creditworthy, with bonds we know exactly what we'll get and when.
In simple terms, we receive the yearly interest (usually paid every six months), which is our reward for certain risks we take such as the above-mentioned credit, but also inflation, duration/time, and other types of risks, and then we get our initial investment back when the bond's term is up. We also get special treatment if anything goes wrong: the borrower must legally give us our money, regardless of whether they're doing great or not-so-great.
Now, when we put our money into stocks (which are pieces of a company that we own), it's a bit more unpredictable. Instead of having a guaranteed return, we go along for the ride with the company. If the company does awesome because of its products, smart leaders, strong sales, and profits going up, we do awesome too. But if things take a downturn, we're in for a bumpy ride with them.
So, why bother with stocks when they come with this extra uncertainty, you ask? Well, it's all about the potential for big rewards outweighing the extra risks we're taking.
That's where the Equity Risk Premium, or ERP, steps in to help us tackle the question: "How much extra am I making for taking on the risk of stocks instead of bonds?"
If only it were that easy...
Now, here's the thing about figuring out the ERP. Like guessing the outcome of a dice roll, it's a theoretical number based on some ideas that could really change the final answer. But what's cool about this number isn't exactly how big or small it is, but what it tells us about how different markets compare. In other words, it provides us with a relative measure between markets.
In the US, the ERP is sitting kind of low compared to its own history. At around 6.0% (figure 1), it's at the same levels last seen around 2006 and 2007, just before the big financial mess we all remember. So, thinking carefully, we're not getting a ton of extra rewards for taking on the risks of stocks over bonds (figure 2). Now, to be fair, the drop in premium mostly happened because of the bumpy ride in the bond market during 2021 and 2022.
Still, even if stocks didn't end up being as pricey as bonds did, it doesn't automatically mean they're a total steal right now. Stocks would be a great deal if we were heading right back to times of super low inflation (under 2%) and companies' profits kept growing like crazy. But we don’t believe we are currently in a one-way direction to super low inflation. Yes, inflationary pressures have abated but we are very susceptible to hiccups in the direction and pace of inflation.
Recognizing the inherent imperfections of the ERP, it remains a commendable yardstick for maintaining a comparative framework. From a mathematical standpoint, the increase in interest rates inevitably triggers a reduction in the present value of future cash flows, and conversely, a decline in rates leads to an increase in this valuation.