From The Capital Spectator:
Estimating the equity risk premium—the return on stocks over a "safe" asset such as the 10-year Treasury or 3-month T-bill—is at the heart of investment research and portfolio analysis. "It is the 'number' that drives everything we do," writes Aswath Damodaran, a finance professor at the Stern School of Business at NYU. The premium "depends strictly on expectations for the future because the investor's returns depend only on the investment's cash flows," advise the authors of the CFA Institute's Equity Asset ValuationHT: Abnormal Returns.
There are three basic methods for estimating the premium, Damodaran notes. You can survey investors and other sources for insight about expectations. You can also analyze history as a guide for thinking about the future. A third approach is crunching the numbers on any number of data sets for clues about the implied premium going forward. Two of the many methodologies in the implied category show up on these pages every so often. Recent examples include estimating the equity risk premium with the dividend yield via a basic application of the Gordon growth model and calculating expected equilibrium risk premiums. There are many other ways to estimate the implied premium, including a methodology that uses consumer confidence metrics, as explained in an intriguing new paper from the Investment Management Consultants Association: "Does the Stock Market’s Equity Risk Premium Respond to Consumer Confidence or is It the Other Way Around?", by Abdur Chowdhury and Barry Mendelson of Capital Markets Consultants.
“The increase in the equity risk premium [i.e., a fall in stock prices] since the beginning of the 2007-2009 Great Recession has led many analysts to believe that risk aversion among stock investors has moved to a permanently higher range in recent years,” Chowdhury and Mendelson write. “Whether the equity risk premium stays within its new wider range—seen in the pre-1960s period—or returns to the range exhibited during the past four decades will prove critically important for stock investors.”
The authors outline a methodology for modeling an idea inspired partly by a recent research note from James Paulsen of Wells Capital Management—"Could ‘Confidence’ Add 50 Percent to the Stock Market?". Paulsen shows that the equity market's premium generally tracks the ebb and flow of confidence in the economy, as measured by the Reuters/University of Michigan U.S. Consumer Sentiment Index. "Since at least 1950, premium and discount valuations of the stock market to its trendline have corresponded closely with periods of strong economic confidence and periods of broad economic fear," he notes. As a result, "a slow but steady revival in U.S. confidence could represent the biggest driver of stock market performance in the next several years!"...MORE
We have an awful lot of posts on the equity risk premium, the quickest way to find them is a Google search of Climateer Investing:
site:climateerinvest.blogspot.com equity risk premiumHere's one from earlier this year:
Knowledge@Wharton on Investor Sentiment and Equity Pricing
