Friday, March 28, 2014

Decoding The NY Fed’s Latest Paper On The Equity Risk Premium

I read academic research papers so that you don’t have to. The NY Fed has recently released a working paper on the ERP. This paper follows a previous paper published last year, which reached similar conclusions. Both papers conclude that the ERP was at an historically high level in 2013. Further, the authors conclude that the ERP is a valid tool for estimating equity market value, and that ERP tools are superior to PE-related tools such as Robert Shiller's CAPE.

You really can’t value stocks through the cycle without reference to bond yields. Otherwise, we would just be looking at PE ratios and be thinking that stocks were expensive when rates were low (2002, 2009, 2012, 2013, 2014). Bottom line: ignore the PE and ignore the cyclically-adjusted PE (the CAPE). Only look at the ERP (earnings yield minus the risk-free rate) or--my preferred index-- the ratio of the ERP to the risk-free rate. Equities can only be valued by reference to interest rates.

If you agree with me, and accept that the ERP/RFR ratio is THE index*, then you should sell everything you own and put it into equities. If you were a real hombre, you would also borrow up to your debt capacity and buy stocks (please don’t do that!). If you accept the internal logic of the ERP/RFR ratio, then you should be overweight equities. Below I have excerpted from the NY Fed’s most recent paper on the ERP, and have provided my parenthetic exegesis. The NY Fed’s words are italicized.

There is broad agreement across models that the ERP has reached historical heights [as of mid-2013] even when the models are substantially different from each other and use more than one hundred different economic variables. Our preferred estimator places the one-year-ahead ERP in July 2013 at 14.5%, the highest level in fifty years and well above the 10.5% that was reached during the financial crisis in 2009.

Translation: The best time to buy stocks in our lifetimes was last summer. If you mentally adjust the ERP to reflect the subsequent market appreciation, we are still in historic territory.

The ERP is high at all foreseeable horizons because Treasury yields are unusually low at all maturities.  In other words, the term structure of equity premia is high and flat because the term structure of interest rates is low and flat.  Current and expected future dividend and earnings growth play only a minor role.

Translation: The reason that stocks are a buy is that bond yields are at deflationary levels.

A high ERP caused by low bond yields indicates that a stock market correction is likely to occur only when bond yields start to rise.

Translation: Unless something happens to upset current inflation expectations, the ERP will remain elevated into the foreseeable future, making stocks a compelling investment.

Another implication of a bond-driven ERP is that we should no longer rely on traditional indicators of the ERP like the price- dividend or price-earnings ratios, which all but ignore the term structure of risk-free rates.

Translation: Shiller’s CAPE and similar crude valuation measures are flawed because they ignore the expected returns from alternative investments. When rates are low, PEs are high. That doesn’t make stocks expensive. We should compare the PEs of stocks with the PEs of bonds. Right now the 10-year PE is ~35x--and bond yields can never rise.

The current high levels of the ERP are unusual in that we are not currently in a recession and we have just experienced an extended period of high stock returns, with 60% returns since July 2010 and almost 20% since the beginning of 2013. During previous periods, the ERP has always decreased during periods of sustained high realized returns. It is unusual for the ERP to be at its present level in the current stage of the business cycle, especially when expectations are that it will continue to rise over the next three years.

Translation: We are living in a period of unprecedented prospective equity returns. This an historical opportunity to buy stocks.

Our analysis provides evidence that is consistent with a bond-driven ERP: expected excess stock returns are high not because stocks are expected to have high returns, but because bond yields are exceptionally low.

Translation: You should only be bullish on stocks if you are also bullish on bonds. That requires an opinion that the FOMC will continue to be unable to raise inflation and inflation expectations.

There was a moment when I thought that Yellen would be the catalyst for higher inflation expectations; I was wrong. She is a catalyst for nothing. We should expect low inflation, low bond yields, and an attractive equity yield premium until stock prices go much higher. Investors who currently hold metals, cash and bonds will look back on 2014 and regret it. Where we are today is 1933, 1974, 1980, 1987, and 2009.
* It was subsequently explained to me (at Seeking Alpha) that the ERP/RFR ratio is unreliable because of its sensitivity to small changes in the RFR when the RFR is very low. Consequently, I suggest that we focus on the ERP itself.

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