Dear Ben,

I recently read an article that suggested a lower earnings yield may explain why the stock market can continue to go up even though the economy and the S&P 500’s earnings remain sluggish. Moreover, how would you explain the Equity Risk Premium to an investor without a finance degree?

Dear Jeff,

The concept of an Equity Risk Premium (ERP) is critical to the stock market, yet very few people understand the relationship. In essence, the equity risk premium is the return required to invest in the equity of a business above what would be the expected return from a risk free asset (such as a CD or T-note). The greater the risk, the higher the expected return, and vice versa. 

Entrepreneurs understand there are high risks to starting a small business, but the payoff can be huge. An individual who saves enough for a down payment on a house wants to know that 100 percent of their savings will be available when needed, and may therefore be comfortable accepting the lower interest rate provided by a savings account or a CD. In periods of low interest rates, the risk free return may barely provide any return at all.

Many strategists calculate the ERP for the stock market by taking the earnings yield on the S&P 500 and subtracting the interest rate on the "risk less" 10-year Treasury note.  The earnings yield represents the inverse of the Price to Earnings ratio, the most common valuation measurement for the market. At current levels, the S&P 500 trades at a P/E ratio of approximately 16.5 times next year's estimate ($132.76e) for an earnings yield of about 6 percent (E ÷ P, or $132.76 ÷ 2184 = ~0.06). Subtracting the 1.5 percent yield on the 10-year Treasury note produces an ERP of 4.5 percent, slightly below the 5-7 percent average of recent years.

The lower ERP available today may suggest that stocks are fairly valued when compared to historical equity multiples and fixed income yields. As a result, some experts have suggested that investors may be willing to accept a lower premium on stocks if they are unable to find any other asset classes that produce enough return to justify the risk. This implies the stock market may not be anywhere near as overvalued as many suggest. If so, the stock market could continue to provide investors with attractive future returns for a lot longer than most expect. But remember Jeff, the essence of portfolio management is the management of risks not the management of returns. All good portfolio management begins and ends with this premise.

—Ben Graham

While a fictitious letter, the insight that stocks may not be all that expensive is not an unimportant point. And even though our proprietary model is “looking” for a near-term pullback attempt, our longer-term bullish stance remains intact. As we wrote in last Friday’s Morning Tack, “Sir John Templeton said, ‘Bull markets are born on pessimism, mature on optimism, and die on euphoria.’ So study a S&P 500 chart, and note that the upside breakout has come after nearly a two-year consolidation, or trading range (chart 1). Then ask yourself, ‘Are we anywhere near optimism, much less euphoria?’”