By Frank Holms
Source: Finding Opportunity Far and Near
Would it surprise you to learn that a vast majority of equity valuation models state that stocks should head much higher over the next five years?
This is research based on 29 different equity valuation models and surveys that use varying economic and market-related data such as dividends or inflation to calculate potential future returns. Using a weighted average, the New York Fed estimated the equity risk premium over the following month.
Simply stated, the equity risk premium is the expected future return of stocks minus the risk-free rate, such as a Treasury bill. For example, if the estimated future return of stocks is 5 percent and a Treasury bond yields 4 percent, the premium is the difference between the two figures, or 1 percent.
Looking back over five decades of annualized results, there’s always some premium for stocks. This intuitively makes sense, because in exchange for taking higher risk, investors expect to receive higher returns.
During these 50 years, the premium nearly fell to zero two times. One time was in 1987, when investors’ exuberance toward the equity market caused stocks to rise quite sharply.
The most recent dip in the equity risk premium was at the height of the great tech boom in 2000. Many investors remember triple-digit price-to-earnings multiples. And some companies saw terrific price appreciation even though there were no reported earnings to be had at all. You’ll remember Fed Chairman Alan Greenspan coining the phrase, “Irrational Exuberance.”
Looking at the chart above, today we see an opposite picture. In fact, today’s equity premium is at 5.4 percent, as high as it was in November 1974 and January 2009.
And what happened in these two time frames? Well, we saw the dramatic increase in equity prices from 2009 to today.
Back in the 1970s, investors experienced the collapse of the Bretton Woods system and “a terrible case of stagflation,” says the Fed of New York. However, that didn’t stop the stock market, as gains were incredible, increasing nearly 15 percent on an annualized basis from 1974 to 1979.
The chart illustrates a tremendous case for U.S. stocks over the next five years. We’re not the only bulls in this field: Business Insider lists economist Jim O’Neill from Goldman Sachs, hedge fund manager David Tepper and Barry Ritholtz as experts who “all love this bullish stock market metric.”
