Ozempic comes for the ERP
There are a lot of different ways to calculate equity risk premia (ERP). Our graph below looks at a few of these.
You can take a measure like the S&P 500 forecast earnings yield, and subtract the risk-free rate, say, the US 10yr treasury bond rate. You can go a step better by using real risk-free rates, using either TIPS (Treasury Inflation Protected Securities) or using a measure of expected inflation from the SPF (Survey of Professional Forecasters).
You can attempt to calculate the equity risk premia by wedging a proxy for the long-run rate of real earnings growth, to get a more complete measure (e.g. an ERP with growth estimates included, wg, or excluding it, xg).
And, in our view, you can normalise for the business cycle, by using a Shiller CAPE earnings yield (Cyclically Adjusted Price-Earnings ratio).
That's how the graph below comes together. What does it tell us?
![](https://assets.livewiremarkets.com/rails/active_storage/blobs/proxy/eyJfcmFpbHMiOnsibWVzc2FnZSI6IkJBaHBBMlFjQ0E9PSIsImV4cCI6bnVsbCwicHVyIjoiYmxvYl9pZCJ9fQ==--ca9b6ca0b072cdfed60c708617be8bf4610d0b51/page_43_erp_pe_bubble_index.png)
Well, we can note that ERP's got very skinny in 1999, just prior to the tech wreck. We can note it averaged a little over 5% in the years after the huge market sell-off, and that as a "line in the sand" it's been a reasonably useful guide to over or undervaluation.
However, on current numbers, however, you choose to dice it, that ERP is not very large. There is a degree of increasing euphoria, as the market believes that good growth continues, AI benefits a handful of listed firms, unemployment stays low and inflation recedes.
That may all well still happen, but, are you fairly compensated for the risk it doesn't?
That's a question investors need to be asking themselves.
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