Friday, September 24, 2010

Why is the Equity Risk Premium so high?

Market observers are puzzling over the historically-high level of the Equity Risk Premium. The ERP is the difference between the S&P 500 earnings yield (the reciprocal of the P/E) and bond yields (you can pick various maturities and types, either AAA corporates or corporates or BBB corporates or Treasuries).

By any such measure, the ERP is very high. You are being paid a nice yield to hold equities and almost nothing to hold bonds. This suggests that you should short bonds and buy stocks if you believe in “convergence” (reversion to mean). So why isn’t everybody and his brother shorting the bonds and loading up on equities?

I can think of three possible explanations. 

One is that equity volatility has been so high that the market is irrationally underweighting equities and overweighting bonds. Clearly some of this is going on with retail investors.

A second possible explanation is that the market expects deflation, which would be bad for stocks and good for bonds. As long as Ben Bernanke is alive, I don’t see this happening.

A third explanation is that the market is discounting a major exogenous shock, which would clobber equities and force a stampede into high quality bonds (and gold).

I can see three possible exogenous shocks on the horizon (in declining order of probability):
  1. One of the PIIGS defaults and there is chaos in the debt markets leading to contagion all over the place (other indebted countries, European banks).
  2. Israel and/or the US attacks Iran; Iran attacks the Gulf countries and closes the straits. Oil goes to $250 or higher.
  3. The North Korean regime decides to exit history with guns and rockets blazing.

As you know, I think that exogenous shock #1 is almost inevitable, and I am very worried about it. The other two could happen but are not inevitable.

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