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What are US Equity Risk Premiums Telling Us?

Feb 12, 2018

What are US Equity Risk Premiums Telling Us?

Why do you care about equity risk premiums and what are they telling us? Equity risk premiums (ERP) are defined as the return above the risk-free-rate that investors require from equities. The ERP is a key component in the Capital Asset Pricing Model (CAPM). A high ERP suggest investors view equities as risky while a low ERP would suggest investors view equity as less risky.

According to Bloomberg’s multi-factor model, US equities are imply a 7.45% ERP which is well above the long-run average of 6%. A reversion to the long-run average would suggest a 24.8% rally in US stock markets. During periods of economic expansion, the ERP has fallen to the 3-4%. As an example, last year, the ERP was ~7% even with a 21% rally in the S&P500. If we assume the ERP contracts to last year’s level, that would imply 6% upside to US equity markets from this level.