The Federal Reserve of New York posted a blog entry titled "Are Stocks Cheap? A review of the evidence." The media picked up on the report and the headlined read "NY Fed Study: Stocks Have Never Been Cheaper." Researchers at the Fed did a study on the risk premium of the stock market and reached the conclusion that the stock market is extremely cheap on a historical basis. Unfortunately their research methodology wasn't well defined in the posting.
The equity risk premium is the expected future return of stocks minus the risk-free rate over some investment horizon. Because we don't directly observe market expectations of future returns, we need a way to figure them out indirectly. That's where the models come in. In this post, we analyze twenty-nine of the most popular and widely used models to compute the equity risk premium over the last fifty years. They include surveys, dividend-discount models, cross-sectional regressions, and time-series regressions, which together use more than thirty different variables as predictors, ranging from price-dividend ratios to inflation.
They did however post a graphic of their findings.
Personally I thought their approach was a bit odd and complicated to calculate a risk premium, and had they chosen 29 different studies, they would have gotten 29 different charts. The arbitrary nature of the selection of what was included makes this study a bit suspect in my opinion. I attempted to recreate the spirit of this study in a much more common sense and simple approach. I calculated the risk premium of the stock market as its earnings yield minus the 10-Year Treasury yield and the 3-month T-Bill yield.
The S&P 500 yield minus the 10-Year Treasury rate comes pretty close to replicating the above chart created by the Fed.
The S&P 500 yield minus the 3-Month T-Bill rate also does a decent job replicating the Fed study.
I then took the S&P 500 Yield minus the 10-Year Treasury yield (risk premium) and overlaid the SNP 500 to see if there is any predictability to this study. From this chart, if anything, it looks like very low-risk premiums are associated with strong stock markets, not high risk premiums.
I then overlaid the forward 12-month performance of the S&P 500 compared it to the risk premium. There appears to be no relationship between the two, in fact the peaks of the 12 month performance occurred when the risk premium was near a low.
In conclusion, the Fed's study is a nice academic exercise but it doesn't appear to provide much of a forecasting tool. The stock market has performed well during times when the risk premium is high and when it is low. One factor different about this period of a high risk premium is that it is being artificially inflated due to the Federal Reserve's quantitative easing. Looking forward rates are likely to increase, and lower the risk premium. If that were to happen, I doubt that a shrinking risk premium will have the effect investors hoped for. Theoretically one would expect stronger earnings would increase the risk premium in the short term, and as the earnings continue to grow and strengthen, confidence would return to the market, and the risk premium would fall driving the stock market higher. Looking forward, that scenario doesn't appear as likely as a falling risk premium due to higher interest rates. That scenario isn't as likely to drive the markets higher as the higher earnings scenario would.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.