The equity risk premium, a comparison of equity and bond yields that is now close to its historical average, can be used as justification that US stocks are fairly valued or even cheap, the position recently taken by Jerome Powell, Chairman of the Federal Reserve.
Although yields are at historically low levels, their recent upward tick appears to be the market’s response to fear of the two-headed monster of slow growth and rising inflation, a circumstance that may likely cause the US Federal Reserve to adopt new policies.
An examination of the policy options available to the Fed leads us to conclude that the central bank will strongly consider yield-curve targeting, which indicates US equities and bonds may be poised for additional positive returns in future.
Now, for ten years we've been on our own,
And moss grows fat on a rollin' stone
But that's not how it used to be.
– Don McLean in “American Pie”
Duration risk, as most investors know, is the risk associated with changes in interest rates. The longer the duration of the asset, the more affected it should be by changes in underlying rates. Duration risk is most often associated with fixed-rate bonds, but equities are also considered long-duration assets. Although opinions vary on how to properly calculate equity duration, a common approach is the inverse of the dividend yield. The dividend yield of the S&P 500 Index has hovered between 1.5% and 2.0% over the last few years, equating to a duration of between 50 and 67 years. This is an interesting factoid, but what does it have to do with anything?
Over the last few years, many in the industry, myself included, have discussed that equities were overvalued, justified by tightening yields and high price-to-earnings multiples. At the same time, others have used the equity risk premium (ERP), a comparison of equity and bond yields, as justification that US stocks, in particular, have actually been cheap. The story goes that stock investors are willing to accept a lower yield because the alternative—bonds—is also trading at a low yield.1