Monday, 15 August 2011


No not something from a John Irving novel... but the Equity Risk Premium.

There have been several commentaries highlighting how "cheap" equities are versus bonds. In essence the ERP is the difference between the earnings yield, ie net profits / market cap for equities against 10yr government bond yields, ie the so called Fed Model.

Does one expect these yields to move in the same way though? in all economic environments? and does it provide a good signal?

Firstly one would expect these two yields to move in opposite directions, ie when the economy is improving, then bond yields should be rising as demand driven inflation rises and long term growth expectations rise, at the same time equity valuations are increasing so equity yields are falling. Whereas in a a recessionary environment the opposite will be true, bond yields fall and equity yields rise. Thus the ERP naturally is going to be counter cyclical, we expect it to be high during recessions, and low/negative in booms. However is it PREDICTIVE?

You tell me?

and would you bet on it?

any guesses for what those charts would look like in Japan??


  1. Where did Japanese p/e yields begin from at the start of the crisis though? Wasn't their stock market on a p/e ratio of 100 or something?

    Likewise the dotcom bubble. Many good quality blue chips have increased their profitability and strengthened their balance sheets through the crisis.

    Now they are yielding 10%+. If you had money you didn't need for 10 years would you buy blue chip stocks or government bonds?

  2. my point is simply that 'valuations' are not a good predictor of future returns.

    for the whole of the 90s valuations would have said that US stocks were expensive, not the nasdaq but the s&p500. you would have missed out on an enormous bull market. you would also have loaded during the 30s and in 2007.

    japanese valuations got out of hand, but again if you had used p/e's you would have missed out on a huge bull run, and then invested after the bubble had burst and suffered losses.

    using the ERP is even worse in my opinion, right now there are two things that are clear;
    1) bond markets are saying there is a substantial risk to growth, and odds on we see deflation - which is very negative for stocks. if interest rates were 5% and we had a 15 p/e I would be much happier buying stocks.
    2) the "E" is a risky number, and right now it looks very inflated, profit margins are very fat, and they do tend to mean revert.
    3) its not a choice just between bonds or stocks.