Tuesday, May 28, 2013

New York Fed: "Are Stocks Cheap? A Review of the Evidence"

Some of the 29 models used come awfully close to being a rehash of the Fed Model which worked for a few years in the '80's and '90's and has since been shown to have little predictive "Skill".
Another problem with the models is the earnings assumptions in some, they take as a given that current profit margins will hold. That is really debatable.
From MoneyBeat:

The New ‘New Paradigm’ for Equities 
There’s a vigorous debate about whether U.S. equities are overpriced or fairly valued.

One side argues that shares are expensive relative to past price-to-earnings and replacement-cost metrics. The other points out that set against Treasury bond yields and profit expectations, shares are–at the very least–fair value and quite probably cheap.

The bears have been wrong throughout this booming bull market.

But the bulls seem to be slipping into the sort of “new paradigm” thinking that many, including then Federal Reserve chairman Alan Greenspan, used to justify the ill-fated tech bubble of the late 1990s.

Maybe this shouldn’t be surprising, given the weight central bankers have put on wealth effects to lift their domestic economies, and, once again, the Federal Reserve has thrown itself behind the bull case. A paper earlier this month by Fernando Duarte and Carlo Rosa of the New York Fed, “Are Stocks Cheap? A Review of the Evidence,” came out with a pretty unequivocal “yes.” Yes, they are cheap.

The Fed researchers look at 29 economic models that estimate the equity risk premium–the expected excess return equities deliver over safe bonds. The average risk premium at the end of December was 5.4%, about as high as it’s ever been since the early 1960s. The only two previous periods when the risk premium was this high were back at the end of 1974 and just before the market hit its post-crisis low in 2009.

There were clear reasons for the risk premium to be that high in 1974 and 2009–in the former, Bretton Woods had just collapsed, there had been an oil crisis and the economy was racked with stagnation, while the latter was the low point of the biggest financial implosion since the 1930s.

But why again now?

The equity risk premium is dependent on both expected dividends and the yield on the “risk-free” benchmark. And it’s these current extremely low bond yields that are behind the high risk premium.
And that’s a major source of risk for investors.

If recent evidence of a rebound in the U.S. economy holds, Treasury bond yields aren’t likely to stay as low as they are much longer. Yields on 10-year Treasurys have risen 0.38 percentage point over the past month and are at around their highs for the past year.

Should the Fed’s quantitative-easing program wind down faster than people think, yields could shoot upward rather quickly.

But that’s not the only risk facing equities. U.S. corporate profits as a percentage of total GDP are at historic highs. As the government pares back its huge deficit, those profits are likely to come under pressure. What’s more, a rebound in corporate investment amid stronger economic growth is likely to increase competitive pressures, paring away even further at those excess returns.

The bullish case for equities now seems to hinge on the new paradigm thinking that profitability will stay historically high while the Fed keeps bond yields low well into a recovery.

Maybe, but to judge by recent talk of the Fed tapering its quantitative-easing program, it is only likely to keep pumping current levels of liquidity if the recovery weakens....MORE
Previously on the Risk Premium Channel:
Equity Risk Premium: "How much should people get paid for investing in the stockmarket?"
What Risk Premium Is “Normal”?
A Really Smart Guy On Stocks, Bonds and Expected Returns
"The Real Role of Dividends in Building Wealth" (Clearing Up Muddled Thinking about Dividends)
The Equity Risk Premium: "Using Garbage to Measure Consumption"
Equity Risk Premium: "Why the market’s rate of return—and your nest egg—may never recover"
Knowledge@Wharton on Investor Sentiment and Equity Pricing
"What Does Consumer Confidence Imply For The Equity Risk Premium?"
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 premium
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