Here's The Chart That David Tepper Just Showed To Argue That Stocks Are Still Incredibly Cheap

David Tepper is on CNBC arguing that stocks are still a buy.

During his appearance, he held up a chart from the blog Liberty Street Economics, which is a blog hosted by the New York Fed.

The chart he shows shows the Equity Risk Premium, wbhich is the gap between expected return on stocks vs. bonds.

Based on traditional measures of the Equity Risk Premium (ERP) stocks are about as cheap as they’ve been in 50 years, a function somewhat of ultra-low bond yields.

From the Liberty Street Economics blog, here’s an explanation of the ERP and the chart which shows that stocks are relaly cheap.

We surveyed banks, we combed the academic literature, we asked economists at central banks. It turns out that most of their models predict that we will enjoy historically high excess returns for the S&P 500 for the next five years. But how do they reach this conclusion? Why is it that the equity premium is so high? And more importantly: Can we trust their models?          

The equity risk premium is the expected future return of stocks minus the risk-free rate over some investment horizon. Because we don’t directly observe market expectations of future returns, we need a way to figure them out indirectly. That’s where the models come in. In this post, we analyse 20-nine of the most popular and widely used models to compute the equity risk premium over the last 50 years. They include surveys, dividend-discount models, cross-sectional regressions, and time-series regressions, which together use more than 30 different variables as predictors, ranging from price-dividend ratios to inflation. Our calculations rely on real-time information to avoid any look-ahead bias. So, to compute the equity risk premium in, say, January 1970, we only use data that was available in December 1969.          

Let’s now take a look at the facts. The chart below shows the weighted average of the 20-nine models for the one-month-ahead equity risk premium, with the weights selected so that this single measure explains as much of the variability across models as possible (for the geeks: it is the first principal component). The value of 5.4 per cent for December 2012 is about as high as it’s ever been. The previous two peaks correspond to November 1974 and January 2009. Those were dicey times. By the end of 1974, we had just experienced the collapse of the Bretton Woods system and had a terrible case of stagflation. January 2009 is fresher in our memory. Following the collapse of Lehman Brothers and the upheaval in financial markets, the economy had just shed almost 600,000 jobs in one month and was in its deepest recession since the 1930s. It is difficult to argue that we’re living in rosy times, but we are surely in better shape now than then.

Liberty Street Economics

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