New York Fed economists Fernando Duarte and Carlo Rosa are out with a new article on Liberty Street Economics titled, “Are Stocks Cheap? A Review of the Evidence.”
The answer: judging by the equity risk premium (ERP), stocks are about as cheap as they’ve ever been.
The ERP is the excess return that stocks are expected to provide over the risk-free rate, and it’s typically calculated as the expected future return of stocks – based on historical averages, or forecasting models, depending on whichever one is chosen for the calculation – minus the risk-free rate (typically the yield on a U.S. Treasury bond) over comparable time horizons.
To calculate the ERP in the chart above, Duarte and Rosa collected “20-nine of the most popular and widely used models” for forecasting stock returns and incorporated the average expected return into the ERP calculation.
“We surveyed banks, we combed the academic literature, we asked economists at central banks,” they write. “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.”
However, Duarte and Rosa also find that the high ERP is driven mostly by record low Treasury yields as opposed to expectations for high absolute returns in stocks.
They also test the efficacy of the models used to forecast the ERP vis-a-vis just using the historical average return, and they find that most of the models are actually more accurate than the historical average, especially over longer time horizons.
The economists conclude:
At face value, this result means that the models are actually helpful in forecasting returns. However, we should keep in mind some of the limitations of our analysis. First, we have not shown confidence intervals or error bars. In practice, those are quite large, so even if we could have earned extra returns by using the models, it may have been solely due to luck. Second, we have selected models that have performed well in the past, so there is some selection bias. And of course, past performance is no guarantee of future performance.