Seeking Alpha
Value, newsletter provider, macro, financial markets
Profile| Send Message|
( followers)  

On October 8th, I wrote that equity investors should ignore the "budget crisis" because stock prices were low ("Forget The Debt Ceiling: Stock Prices Are Very Low"). That was the point at which the pundits were telling us to stock up on canned goods ("worse than 2008"). The day I wrote that post, the Dow closed at 14,773.

On Friday (10/18), the Dow closed at 15,400 - a gain of over 600 points in 10 days. Once again, we have relearned the lesson that there is very little actionable information in the A section of the paper, and not much more in the business section. Actionable investing information is found in the calculation of market valuation, not in the blathersphere.

On October 1st, Damodaran calculated the Equity Risk Premium at almost 6%. It has been hovering in this vicinity since the Crash. The ERP had not been this high in absolute terms since the inflationary Carter years; it has historically trended around 3%. As a multiple of the risk-free rate, the ERP has never been this high (3.3x). Over the past 50 years the multiple has remained below 1x, generally in the .5 to .7 range. Today, the multiple is about five times its historical average. Hence, the compelling imperative to remain heavily exposed to the stock market.

Should the ERP and the ERP multiple revert to their historical levels (of 3% and .6x), the stock market would be perhaps 2-3x its current level, without factoring in future earnings growth. I would also point out that corporate earnings do not need to grow for market EPS to grow. Many companies today have excess free cash flow, and are using it to reduce their float (the denominator for the calculation of EPS) and thus increase earnings per share.

It is true that higher bond yields would also reduce the ERP. That is a risk to the rosy scenario. But given the fact that inflation remains at extremely low levels, and that the Fed is unlikely to adopt a radical reflationary policy, the prospects for higher inflation are bleak.

Many market analysts are focused on the fact that today's market P/E ratio (18.2x) appears quite high in an historical context. This might be a useful factoid if today's interest rates were anywhere near their historical norms. But interest rates are at levels never seen before, not even under the gold standard. Therefore historical P/E comparisons are meaningless. The market is very cheap.

Source: Bearish Scenarios Lack Credibility