By many measures, stocks look cheap. With 2012 EPS estimates for
the S&P 500 around $103, the index at 1,320 is currently
trading at a P/E under 13X. And based on 2013 top-down estimates
near $110, the forward multiple gets juicier at only 12X.
Granted estimates are just that and, a year ago,
2012 projections were also close to that $110 mark but
had to come down due to slower-than-expected US growth, the
European financial crisis, and the deceleration in
China.
There is no doubt that US corporate profits are strong and seem
to be holding up in the face of global worries. But is the
stock market trading below its mean historical valuation near
15X (during a cyclical expansion) solely because of Europe?
(That's a hefty discount of at least 20%).
Or have "lean and mean" profit margins peaked and
are estimates due to come down due to pressures both here and
abroad?
One way that longer-term investors can get some perspective
is to not only look at valuations, but to visualize the
"equity risk premium," or ERP for short. It is designed to
tell you the excess return you can expect from investing in stocks
vs. risk-free bonds.
Since I am neither an economist nor "CFA-trained," take my
simple explanation as just that. There are tons of papers debating
the theories and methods of calculation that we don't need to
bother with for this discussion.
ERP is simply the "earnings yield" of the market minus
the risk-free rate.
$103/1,320 = 7.8% minus 1.6% (10-yr yield) =
6.2% ERP
Yes, the ERP is "artificially" high because US government bond
yields are so low. But this is still worth talking about because
the current low rate regime is still very good for equities both
from a economic growth perspective and an investment
alternatives perspective.
This graph taken from August 2011, shows how last summer's
decline in stocks produced an ERP near historic highs.
At that time, the calculation looked like this...
$95/1,205 = 7.9% minus 2.25% (10-yr yield) =
5.6% ERP
And I said long-term investors should buy stocks and the S&P
500 near 1,100 with both hands because it was an "extreme value
area" both fundamentally and technically.
Are we approaching more extreme value?
Or is there more than enough risk to justify this premium
and push it even higher (which means stocks go lower)?
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