James Swanson MFS: What the equity risk premium is telling us

There are several ways investors look at stocks to assess their relative value. Many look to the stock market?s price-to-earnings or P/E ratio; others flip that ratio to look at the market?s earnings? yield. I think the more compelling measure, however, is one that shows how stock yields compare with bond yields. The difference between these two yields is the equity risk premium.

This premium is one of the best indicators I have found to determine whether investing in stocks is a better option than putting money into bonds. It represents the extra return that investors demand for investing their money in a risky versus a low risk asset. The premium, now at 4.5%, is extremely high, suggesting that stocks are a better value than bonds.

We can take this all to mean that stocks are cheap or bonds are expensive. If we assume that the equity risk premium is going to revert to its historical average, or normal, it is typically assumed that one of the following three things might happen:

1. Bond yields could rise. Such a rise would mean an immediate drop in bond prices. This could be a shocker if investors are still long bonds when this happens. Typically interest rates rise when there is strong growth in the economy or when inflation is accelerating. Neither of these conditions is present at this time.
2. Earnings could fall. This usually happens in recessions or during big slowdowns in the economy. Typically in a recession, the stock market drops if earnings are falling.
3. Stock prices could fall. If stock prices were to fall as much as earnings, the ratio might stay the same. The two are related.

While the above outcomes are possible, I foresee a fourth result. I expect that US economic growth will continue and that US corporate earnings will keep rising, albeit at a slower pace. In turn, real interest rates will rise. These conditions would put a foundation in place for stocks to outperform.

No forecasts can be guaranteed.

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.

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Source: http://jamesswansonmfs.blogspot.com/2012/09/what-equity-risk-premium-is-telling-us.html

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