Equity Risk Premium Levels Suggest March Lows Will Hold

Jul. 7.09 | About: ProShares UltraShort (SDS)

Last quarter, we dusted off the “Fed Model” to look at historical risk premiums and their relationship to earnings. At the commencement of earnings season we shall once again return to the Fed Model and examine the market reaction to spikes in risk premium.

Robert Shiller of Yale University has done extensive work on the P/E ratio of the S&P 500. Moreover he is gracious enough to post online his raw historical data on both the S&P 500 and long term bond yields. It is from this data that we have drawn the following analysis.

As a refresher, the term “Fed Model” was coined by Ed Yardeni when he referenced research the Federal Reserve conducted on the equilibrium between the yield on 10 year Treasuries and the earnings yield of the S&P 500 index. Simply stated, the Fed model suggests that the yield on 10-yr Treasuries should be equal to the earnings yield on the S&P 500. The earnings yield is simply the P/E ratio upside down or earnings divided by price.

While rarely at “equilibrium” the Fed model can be used to compare the relative value of Treasuries to equities. When the earnings yield on the S&P 500 is greater than the 10 year yield, the Fed model suggests investors should sell Treasuries and buy Equities. The difference between the yields is referred to as the risk premium. We used the data from Robert Shiller to construct the risk premium from 1881 to 2009.

Click to enlarge:

Risk Premium (Earnings Yield – 10 Year Treasury Yield)

The yellow highlighted circles represent periods of extreme risk premiums, that is to say a “peak” in risk premium. Since 1881 there have been 10 major peaks in risk premium; 9 out of the 10 peaks resulted in a major market rally at the 3, 6 and 12 month time horizon.

The peaks and subsequent S&P 500 returns are presented in the table below.

Click to enlarge:


It is clear to see that with the exception of the December 1920 peak, the S&P 500 experienced significant appreciation over the next 3, 6 and 12 months.

The accuracy and subsequent rise in the S&P 500 requires our undivided attention to this indicator. Since the March 2009 peak in risk premium the S&P 500 has risen 34.44%. Based on historical evidence we would expect the S&P 500 to continue its rise over the next 9 months.

Interestingly, the period that experienced the largest percentage gain was 1932-1933. The resemblance of today’s markets to that period is uncanny. What’s more is 1932-1933 was the only period in which the 6 month return was less than the 3 month return.

This fits with our technical take that the current leg up was the first 1/3 of this correction within a bear market. Furthermore, this would suggest the downtrend that began on June 11th will not break the March 2009 lows.

Disclosure: I am long SDS, for now…