How and Why to Use Equity Risk Premium

Every investor knows the old saying "buy low and sell high," but in the stock market, there's a difference between low prices and cheap prices. Thankfully, tools like equity risk premium (ERP) can help investors and traders gauge the value, or lack thereof, in stocks. 

ERP measures the compensation investors demand for owning equities over safer assets, offering a peek into market sentiment and whether valuations are appealing or stretched. Like all valuation tools, however, ERP has limitations. It's often difficult to interpret and has proven to have limited predictive power historically, meaning traders should use it with caution. 

ERP can still serve as a guide to help value stocks, compare asset classes, and set expectations for future returns, but it should always be just one instrument in a larger toolkit. 

ERP is the additional return investors expect to receive when investing in stocks compared to so-called risk-free assets, chiefly U.S. Treasuries. This premium is the compensation traders receive for the additional risk that comes with holding equities. 

Typically, it's calculated by subtracting the 10-year Treasury yield (a widely used benchmark for the risk-free rate) from the expected return of the S&P 500^Ò index. For example, if the expected return for the S&P 500 over the next year is 10% and the 10-year Treasury yield is 4%, the ERP would be 6%. 

But there is no universally accepted method for calculating ERP, and numerous methods are used by market watchers. One of the most common is called the implied ERP, which subtracts the 10-year Treasury yield from the forward earnings yield on the S&P 500, offering a forward-looking estimate of equity risk. 

Some ERP models rely on historical stock market return data or surveys of investors, while others use complex dividend discount, time series regression, or cross-sectional regression models for their calculations. 

After becoming familiar with the concept of ERP, the next step is learning how investors put it to work. 

The ERP is sometimes used as a predictive tool, but it may be more useful to view it as a gauge of investor sentiment. Rising ERP can signal heightened concern about the economy, corporate earnings growth, or financial stability, while falling ERP can reflect optimism and an increasing risk appetite among investors. 

Traders may also use ERP as a valuation metric to help measure the current risk-reward proposition in the stock market, making it a useful tool for portfolio allocation. It can therefore shape decisions about whether to favor stocks or shift portfolios toward bonds or other assets. 

But using ERP as a valuation metric for portfolio allocation requires caution. It will never provide a definitive answer, only a signal that requires interpretation. And interpretation can be difficult because there isn't always a straightforward conclusion to draw. 

A trader might notice, for example, that the ERP is quite high relative to its norm. This could reflect weak investor sentiment, but it also might suggest stocks offer a larger-than-usual risk-adjusted reward compared to safer assets. This sometimes prompts traders to opt for a heavier equity allocation in their portfolios. 

Conversely, when the ERP is unusually low, it can signal optimism among equity investors. But it can just as easily be a sign that bonds are more attractive on a risk-adjusted basis, leading investors to shift to a more conservative, fixed-income-focused portfolio. 

It ultimately comes down to interpretation. 

Taking all of this into account, it's important to remember the limitations of ERP for capital allocation. It can help investors align their portfolios with their risk tolerance level, but it's not a guaranteed predictor of future risk or returns. 

"Investors can use [the ERP] as one input among many, but keep in mind that using an array of metrics tends to be beneficial, especially when constructing a diversified portfolio," said Kevin Gordon, senior investment strategist at Schwab. 

Wall Street analysts and portfolio managers also use ERP in various ways. Primarily, they rely on it to frame discussions of the stock market's valuation. When the ERP is high, it typically signals the stock market is undervalued relative to other assets, while a compressed ERP can be evidence that stock market valuations are stretched. 

ERP also plays a central role in many Wall Street analysts' single stock valuation models, particularly the popular discounted cash flow (DCF) model, in the ERP and the risk-free rate are added to determine the cost of equity. This cost is then used as part of the benchmark to discount a company's future cash flows back to a present value. Therefore, a higher ERP tends to lower Wall Street analysts' individual stock valuations, while a lower ERP raises valuations. 

Beyond the Street, corporations may use ERP as a key input when calculating their cost of equity, which feeds into their overall cost of capital. Cost of capital is then used to evaluate the feasibility of new projects. As a result, a higher ERP means companies must justify capital allocation decisions with higher expected returns, and a lower ERPs means there is a lower minimum acceptable return on investment. 

Essentially, the ERP can influence which business opportunities a company pursues and how they allocate their resources. The takeaway for investors is that the ERP helps not only to gauge market sentiment and value equities, but it also shapes real-world decisions that companies make, including decisions that drive long-term returns. 

Using equity risk premium to inform investment decisions comes with significant risks, mainly due to the complex nature of interpreting it. And while some traders use valuation tools like the ERP to time market entries and exits, many experts argue that attempting to time the market is a fool's errand. 

"Valuations are a horrible market-timing tool, as if a good one even exists. There isn't a strong correlation between valuations and forward returns," said Gordon. "While one can point to the deeply negative ERP in late 1999 and show how dismal stock performance was during the tech bust, one can also point to the deeply negative ERP in the early 1990s, which preceded a strong bull run." 

Beyond the risk of misinterpreting the ERP or improperly using it for market timing, there are several other risk factors to consider: 

• Model selection risk. Different methods for calculating ERP (historical averages, forward-looking models, etc.) often produce very different end results, making it difficult for investors to know which ERP to rely on.
• Market-driven distortions. Market swings—rather than changes in fundamentals—can compress or inflate the ERP. For example, rising stock prices or higher bond yields can push the ERP down, signaling investors are accepting more risk for less potential reward (when that may not actually be the case).
• Historical bias. Some methods for calculating ERP use historical returns as an input. This data can be distorted by unusual market periods (like recessions or bubbles) as well as structural shifts in markets or economies that may not reflect future returns.
• Survey limitations. When calculating ERP using surveys of investors, estimates can be subjective and inconsistent across respondents. This leads them to capture investor sentiment rather than an objective valuation measure or predictor of expected returns.
• Country-specific risks. ERP levels vary across markets due to differences in countries' characteristics like political stability, economic growth, or capital market development. Using a global average for ERP without factoring this in can distort valuations and mis-price risk. 

While ERP can be a useful valuation metric for the stock market, it's far from perfect. And many investors may avoid using it strictly as a predictive tool due to its limitations. 

Even if the ERP indicates valuations are stretched, it doesn't mean a bear market is coming. And betting against supposedly "irrational" markets doesn't always pay off. As the old saying goes: Markets can stay irrational longer than you can stay solvent. 

Ultimately, ERP isn't a crystal ball, but it can still be a valuable tool equity investors and traders can use to weigh potential risks and rewards. By understanding its signals—and their limits—traders can make more informed choices about when to lean into opportunities and when to proceed with caution.