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Seed Weekly - The US Equity Risk Premium

BCA Research agrees with the general consensus that US equities are fully priced or indeed even possibly slightly overvalued. They do say, however, that “Nevertheless, this does not mean the bull market is about to end. In fact, history has shown that valuation is a bad market-timing tool; equities can stay in over- or under-valued territory potentially for decades.”

At the same time it is important for investors to always have a good understanding of the valuation of the market in order assess the level of risk. While there are numerous ways to look at the overall valuation of equities, one methodology is to look at the equity risk premium (ERP). The thinking here is that investors demand a premium in the yield for investing into a more volatile asset such as a listed share when compared to the yield on a government bond.

The yield that an investor receives on a government bond – for instance a 10 year bond – is generally considered risk free because of the low probability of default. Because an investment into the shares of a company has a much higher degree of risk, it stands to reason that the yield demanded is higher than bonds – hence the equity risk premium. It is because of this premium in yield and the compounding effect of earnings that investors in equities will typically be rewarded with excess returns over time.

The maths then to calculate this equity risk premium is fairly simple – it is the difference between the 12 month forward earnings yield and the yield on the 10 year government bond.

This premium, however, has not been a fixed number over time as depicted in the chart below for the S&P 500. At certain times investors become more exuberant and demand a very low, or at times discount in the yield versus bonds. At other times investors become very nervous about risk assets and demand a high yield (i.e. lower valuation) relative to the lower risk bonds.

In the 1980s to 1990s, the average equity risk premium on the US market was 80 basis points, which was very low because the stock market was overinflated and overvalued for more than a decade. Then into the late 1990 and early 2000 there was a major shift where investors no longer demanded a premium for investing into equities and in the years to just before the global financial crisis, investors demanded an approximate 200 basis point premium over 10 year bonds.

With prices plummeting into the global financial crisis, yields moved higher and the equity risk premium spiked to over 600 basis points, but has since been dropping. The big question, however, is just what should this equity risk premium number be?

The current yield on the US 10 years bond is around 2.5%. Assuming that the long run number should be 3.5% and that investors demand an additional 3% equity risk premium, this means that shares should trade at a yield of 6.5%. This yield implies a price to earnings (PE) ratio of 15.4 (i.e. 1/6.5%). Currently the US stock market, as defined by the S&P 500, is trading on a forward PE of 15.7, which means that on these assumptions it is in equilibrium territory.

Investors can therefore take comfort that on this basis, overall valuations are reasonable but this does not guarantee that prices will not be volatile.

Kind regards,

Ian de Lange

021 914 4966

Tue, 22 Jul 2014- 10:52

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