The single, best way to tell whether stocks are worth it

Volatile Trading Day On Wall Street As Fears Over Euro Zone Continue
NEW YORK, NY - MAY 23: Traders work on the floor of the New York Stock Exchange May 23, 2012 in New York City. After a volatile trading day where European stocks saw record lows, the Dow Jones Industrial Average dipped as much as 191 points but ended just off 6.66 points at 12496.15. (Photo by Allison Joyce/Getty Images)
Photo by Allison Joyce—Getty Images

Investors have come down with a case of the jitters, and for a good reason.

Since September 22, the Dow has careened through three days of 100 point-plus losses. The gigantic pop in the Alibaba IPO and the Chinese e-commerce phenomenon’s epic valuation have begun to stir fears that we’ve hit a market peak.

What’s worrying is that prices are displaying far greater faith in the future than the unimpressive fundamentals suggest is warranted. We’re living in a world of record-high corporate valuations and mediocre earnings growth.

To get the most accurate picture of the situation, let’s examine a metric that tells you when stocks are really a buy, and when they’re overly pricey. It’s called the Equity Risk Premium, or ERP, and it’s been lauded as the Holy Grail of corporate finance. The name may sound wonky, but for making money in stocks in the long-term, it’s the most practical measurement you’ll ever find.

The Equity Risk Premium is the extra return that investors demand for taking the additional risk of choosing stocks over far safer Treasury bonds. The higher the ERP, the bigger the potential future returns. Risk premiums ballooned, for example, in the panic of 2009, and folks who bought then profited handsomely. By contrast, when the ERP is below average, gains on equities tend to be weak or non-existent in the years to come.

What’s misleading is that the real, sustainable ERP has been disguised by a temporary phenomenon: unsustainably low interest rates. But it’s no great challenge to unmask an adjusted, realistic ERP from the illusory, official one. And as we’ll see, that slender figure is cause for alarm.

The ERP is simply the expected return on equities minus the inflation-adjusted yield on 10-year treasuries—that’s the extra cushion, or margin for error, you’d expect for braving equities. The best measure of the expected return is the earnings yield on the CAPE, or Cyclically Adjusted Price-Earnings Ratio, developed by economist Robert Shiller. The CAPE is the most reliable yardstick for returns since it adjusts for temporary, highly misleading swings in profits. Right now, the E/P (earnings to price ratio) on the CAPE stands at 3.8%. That’s the inverse of the Shiller price-to-earnings ratio of 26.3.

So the expected return on stocks is now 3.8%, adjusted for inflation. The second step consists of subtracting the real rate on the 10-year Treasury to get the ERP. The long bond is now yielding around 2.5%, and inflation is running at around 2%. So the real yield is a mere 0.5%.

Hence, the ERP is our 3.8% expected return minus 0.5%, or 3.3%. By historical standards, that’s a good figure. It’s an encouraging signal for the bulls, even the responsible ones. They can argue that the expected return of 3.8% plus inflation of 2%, or 5.8% in total, isn’t great, but clocks the yields on the long bond. So why not buy stocks?

Even the optimists, however, acknowledge that interest rates need to rise. Today, the incredibly low 0.5% real yield has created a mirage in the form of a superficially strong ERP. Things always go back to normal, so consider the results when the Fed unshackles interest rates and lets them swing back to their historic norms. Over time, real rates hover in the 2% range. What will happen when they rise from today’s level of 0.5% to 2%, bringing the yield on the 10-year Treasury bond to 4% (the total of the 2% real yield plus a 2% premium for future inflation)?

Now, we can re-calculate the ERP to eliminate the funhouse mirror effect of artificially low interest rates. The expected return of 3.8%, minus the reasonable, future real rate of 2%, leaves an under-nourished ERP of just 1.8%.

That’s not enough to justify investing in stocks. Let’s assume investors still demand a spread over bonds of 3.3 points, matching what they’re supposed to be getting today. Now they’ll require future returns not of 5.8%, but 7.3% (that’s the real rate of 2% plus the ERP of 3.3% plus inflation of 2%).

Restoring the ERP to attractive levels will require a sharp drop in company valuations. The Shiller PE would need to fall from 26.3 to 18.9, causing stock prices to drop by 28%. The S&P would look alluring again at around 1,425. Watching the ERP is all about what really matters in investing: ensuring you are well paid for risk. So follow the sovereign of all market metrics.

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