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Tuesday, May 14, 2013

Maybe That Is Why It's Going Up

My last Blog post addressed the continued strength in global equity markets in the face of less than stellar economic news.  One possible explanation I gave is that "it's better than the alternatives".  Well, two Economists (Fernando Duarte and Carlo Rosa _at the Federal Reserve of New York just published a paper titled "Are Stocks Cheap? A Review of the Evidence" , which provides a lengthy academic argument in favor of "beats the alternatives".  

There argument comes down to the measurement of the equity risk premium, which Investopedia defines as:
"The excess return that an individual stock or the overall stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of the equity market. The size of the premium will vary as the risk in a particular stock, or in the stock market as a whole, changes; high-risk investments are compensated with a higher premium."
In other words, investors expect stocks to provide some return over risk-free investments, such asTreasury bonds, to compensate them for taking the added risk of investing in stocks.  We know that the "risk-free" rate of Treasuries is currently close to 0%, so it would follow that the Equity Risk Premium should currently be fairly high, since it doesn't take much to beat 0%.

According to Duarte and Rosa, the equity risk premium is currently at an all-time high, as they demonstrate with the following charts:




Of course, only time will tell if these charts are accurately describing current market conditions and if this measured equity risk premium will translate in continuing strong returns in equity markets.  But, it's nice see some meat on the bones of "beats everything else".  ~FSB