Equity Risk Premium (ERP) refers to the additional return over risk-free interest rate for holding equity.
ERP can be computed by taking earnings yield (inverse of P/E ratio) minus risk-free rate.
Current Fed rate and Current PE ratio
Risk-free rate = Current Fed rate = 5.25-5.5%. Let's take 5.25%.
Current S&P P/E ratio = 27 (it's around 27-28. Let's take 27).
S&P earnings yield = 1/27= 3.7%.
ERP = 3.7% - 5.25% = -1.55%
Current Fed rate and Forward PE ratio
Risk-free rate = 5.25%.
Forward S&P P/E ratio = 23
S&P earnings yield = 1/23 = ~ 4.35%
ERP = 4.35% - 5.25% = -0.9%
Forward Fed rate and Forward PE ratio
Forward Risk-free rate = 4.25% (assuming 4 Fed cut by end 2024)
Forward S&P P/E ratio = 23
S&P earnings yield = 1/23 = ~ 4.35%
ERP = 4.35% - 4.25% = 0.1%
So, the ERP for US equities is either negative or flat. This implies that investors are very confident on the US market that they require no additional return over risk-free rate to hold US equities. If ERP is negative, investors are 'paying' to hold US equities.
In short, US equity market seems overvalued, based on ERP.
(Of course, S&P can still have good returns in 2024, if the sentiment for US market is very good or Fed rate will have more than 4 cuts. I do not know how markets will perform in the future. )
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