US Equity Prices Are Attractive

“You have the large divergence in the market between those who use normalized PE ratios and argue that stocks are massively overpriced and those who use the equity risk premium to make the opposite case...Stock prices are being sustained by four legs: (1) robust cash flows, taking the form of dividends and buybacks at historic highs for US companies, (2) a recovering economy (and earnings growth that comes with it), (3) ERP at above-normal levels and (4) low risk free rates. Thus, my argument is a relative one: given how other financial assets are being priced and the level of interest rates right now, stocks look reasonably priced.”

--Aswath Damodaran, Professor of Finance at NYU, May 2013

For those who wish to intelligently discuss the US stock market, I would recommend Damodaran’s website and his blog. He is the guru of equity valuation, and unlike the equity strategists on Wall Street, his work is available to the public. To my knowledge, not one Wall Street firm publishes its estimate of the Equity Risk Premium (ERP) on a regular basis. I think this is because they want to keep this information close to their chest; it’s too valuable to give away.

Fernando Duarte at the NY Fed also does valuable work on the ERP. I am hoping that, at some point, he introduces a regular data series. That would give us two estimates.

A brief primer on the ERP:

PE ratios are meaningless except in the context of the interest rate. To make it clearer, consider the reciprocal of the PE, the earnings yield. When bond yields are high, the market will demand a high earnings yield. When bond yields are low, as they are now, the market will accept a lower earnings yield. So when people say that the ~15x PE on the S&P is “high”, they neglect to remember that the PE on the 10-year Treasury is near an all-time high at around 36x. In 1981, the PE on the 10-year was around 7x, which was a steal.

The bear view today is that the ERP is artificially high because bond yields are artificially low, due to QE. The bears expect that as QE tapers, bond yields will rise and the ERP (and stock prices) will fall. Many investors expect bond yields to return to “normal”, meaning 4% or so, once the Fed stops buying bonds.

Thus we come to the subject of the outlook for bond yields. Here’s my view: I do not expect bond yields to return to “normal” anytime soon. Bond yields reflect inflation expectations, and I don’t see inflation anywhere on the horizon. Money growth remains stuck at 7% despite QE, inflation is bouncing around 1%, and nominal growth at 2.8% is dangerously weak. Further withdrawal of monetary stimulus is unlikely to raise the rate of inflation or of inflation expectations. Monetary policy, as it is practiced by the FOMC, is broken and unlikely to be fixed anytime soon (unless the president appoints Scott Sumner to head the Fed).

Therefore, I expect bond yields to remain very low, and the ERP to remain high. When the ERP reverts to mean, stock prices will be quite a bit higher and the investment horizon will be very bleak indeed. Damodaran calculates the current ERP at 5.5%, which is an unprecedented multiple of the risk-free rate. We are being paid almost 6% for taking “equity risk”. That makes stocks a safe investment at today’s prices.

Why is the ERP so high? Because of post-Lehman PTSD. Investors are still afraid of another crash. That is our opportunity to buy. Stocks climb a wall of fear.