Stocks are risky assets. Cash in your savings account is not. The equity risk premium or ERP tells us the additional return over the risk-free rate (3 month T-bills or "cash") that investors expect for putting money in the stock market. The ERP is always changing. The biggest determinant is bond yields. About 80% of the variation in ERP is due to changes in bond yields.
This cool chart from (where else?) the Visual Capitalist with data from NYU's Damodaran shows the implied ERP for almost every country (click to enlarge) and how it is calculated. The U.S. with its AAA credit rating had a 5.2% equity risk premium (as of July 2020). Countries with higher perceived risks will require higher returns. So, for example, according to Damodaran's calculations investors would require twice the returns to invest in Bangladeshi stocks than in U.S. stocks, all else equal. Canada, Germany, Sweden and Singapore are perceived to have similar levels of equity risks to the U.S. Sudan, Venezuela and Yemen are places perceived to the have highest equity risks with a ERP of 27.1% each.
A fall in ERP generally signals growing investor appetite for stocks over bonds and is bullish for stocks. A rise in ERP signals the opposite. Damodaran's most recent calculations (thru Feb 2021) show the U.S. ERP at 4.26% down from 5.2% in the chart above, but in the last seven months U.S. stocks have also rallied over 22%. ERP can also be a good relative valuation tool...if the spread in ERP between two countries widens or compresses relative to history it can indicate one market may be under or over valued relative to the other. Of course, there is likely very good reasons for the higher required premium...as they say there's no such thing as a free lunch.
No comments:
Post a Comment