Equity Risk Premium can be defined as the excess return that the overall stock market provides for an investor over the risk-free rate of US Treasury bonds. This excess return compensates investors for taking on the relatively higher risk of the equity market. The way to think about equity risk premium is to define it as the difference between the expected total return of the S&P 500 and the expected yield on Treasury bonds over a period of time.
As an example at the basic level, if 10-year Treasury bonds are yielding 3% annually and the expected 10-year annualized return of the S& P 500 is 5%, the equity risk premium is 2%. In other words, investors are expected to achieve a 2% higher annualized return in the stock market versus the Treasury bond market. The equity risk premium has historically averaged around 4%, which means a 4% better annualized return by investing in stocks over bonds on average. Equity risk premiums in general tend to be higher in recessions and lower in recoveries.
At present, based on calculations of forward earnings, normalized historical earnings, and market valuation models, the average 10-year return projection for the S&P 500 is 4.00% annually. Currently, the 10-year Treasury is yielding 3.25%, making the current equity risk premium .75%; one of the lowest readings in recent years. Of course, we should expect a lower reading in a recovery.
However, the likely premium for equity risk is at the low end of the typical range. Why does this matter? Based on the current assumptions, for a return of roughly .75% over the expected return on Treasury bonds, equity investors are accepting risk that is approximately 3 times greater than that of US Treasury bonds - the risk/reward scenario doesn't seem favorable. The last time the equity risk premium was really low was in the late 1990's, as investors believed stocks would continue to go higher and didn't feel the need to be compensated for the additional risk.
Of course, the expected 10-year annualized return for the S&P 500 is an assumption based on models and could increase from current levels, especially if economic growth improves. If economic growth expands at a faster rate in the future, we should see the expected S&P 500 annualized return percent move higher as well. However, it will need to increase to approximately 7.25%, based on interest rate of 10-year Treasury yield of 3.25%, to reach the historical equity risk premium average of 4.0%. Also, if the 10-year yield continues to rise, the expected annualized return of the S&P 500 will need to increase even more than 7.25% in order to keep pace and move toward the long-term average of 4.0%. Unless economic growth begins to pick up significantly, we should expect the equity risk premium to remain at the lower levels of the range as the economy continues to recover.
Equity risk premiums can also be applied to sectors of the market and there are certain sectors whose equity risk premium is higher than the equity risk premium of the broad market; meaning a better valuation of that sector and the likelihood of out performance versus the broad market in the future.
While investment decisions can't be made on one indicator or valuation model alone, it does help to use various market and risk valuation metrics to assist in the decision making process.
