Stocks are cheap, according to Fernando Duarte and Carlo Rosa, who are both economists at the New York Federal Reserve. They published an article looking over the evidence that suggests that stocks, in general, are a good buy right now. In fact, the evidence seems to indicate that stocks are at their least expensive level in about 50 years.
The Equity Risk Premium
The main piece of evidence they use is the equity risk premium, which is basically the amount stocks are expected to return in the future, less the risk-free rate, which often is the U.S. Treasury bond yield. It is calculated using historical averages and various forecasting models.
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The problem is that there are dozens of different forecasting models that may be used, so how do you know which one is right? Duarte and Rosa looked at 29 different ones to get some ideas of what we can expect from the S&P 500 over the next five years.
A Historic High In The Equity Risk Premium
The economists put together a chart indicating that the equity risk premium was at 5.4 percent in December 2012, which they say is “about as high as it’s ever been.” Other peaks in the premiums were in November 1974 and January 2009, both of which were difficult times economically.
They then compared today’s equity risk premium to the numbers for those two other times in history, and there’s a bit of difference. The chart shows that right now, the premium is rather stable right around 5 percent, although in 2009 and 1974, it drops down a steep slope after each event.
Reasons For The High Equity Premium
According to Duarte and Rosa, there are two potential reasons for today’s high premium. One is low Treasury yields, and the other is high current or future expected dividends. In comparing the 29 different models, they were able to focus in more closely on which of the two possible reasons is more important. In their models, they determined that the extremely low Treasury yields may be to blame for the exceptionally high equity premium.
So are stocks really cheap right now? Economists at other firms said as recently as March that the climbing value of the S&P 500 is making it difficult to find stocks that are undervalued, so it really depends on who you ask.