Implied Equity Risk Premium Calculation in May 2022

Implied Equity Risk Premium Calculation in May 2022

Yesterday, the 𝐒&𝐏 𝟓𝟎𝟎 𝐢𝐧𝐝𝐞𝐱 𝐝𝐞𝐜𝐥𝐢𝐧𝐞𝐝 𝐛𝐲 𝟑.𝟐% 𝐭𝐨 𝐜𝐥𝐨𝐬𝐞 𝐚𝐭 𝟑,𝟗𝟗𝟏.𝟐𝟒. Though the crash was due to increased fed rates to curb the rising inflation, i decided to value the S&P 500 index intrinsically to determine the 𝐞𝐟𝐟𝐞𝐜𝐭 𝐨𝐧 𝐞𝐪𝐮𝐢𝐭𝐲 𝐫𝐢𝐬𝐤 𝐩𝐫𝐞𝐦𝐢𝐮𝐦 𝐝𝐮𝐞 𝐭𝐨 𝐫𝐢𝐬𝐢𝐧𝐠 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐫𝐚𝐭𝐞𝐬.

As of yesterday, the 𝐔𝐒 𝟏𝟎-𝐲𝐞𝐚𝐫 𝐭𝐫𝐞𝐚𝐬𝐮𝐫𝐲 𝐛𝐨𝐧𝐝 𝐢𝐬 𝐚𝐭 𝟑.𝟎𝟒%, 𝐚 𝐬𝐭𝐞𝐞𝐩 𝐫𝐢𝐬𝐞 𝐟𝐫𝐨𝐦 𝟏.𝟓𝟏% 𝐚𝐭 𝐭𝐡𝐞 𝐬𝐭𝐚𝐫𝐭 𝐨𝐟 𝟐𝟎𝟐𝟐, I got the growth rates for S&P 500 index from Edward Yardeni‘s research which provides earnings forecasts monthly.

1)Earnings growth forecast for 2023 and 2024 is 9% and 10%

2)US companies traditionally have returned 80% of their earnings in dividends and buybacks.

I get the intrinsic value of the index as 4,176.35. The last trading value of the index as of yesterday is 3,991.24. Thus, i determined the equity risk premium that the market is factoring in for investing in equities using the solver function.

I calculated the 𝐞𝐪𝐮𝐢𝐭𝐲 𝐫𝐢𝐬𝐤 𝐩𝐫𝐞𝐦𝐢𝐮𝐦 𝐚𝐬 𝟓.𝟐𝟗%, 𝐰𝐡𝐢𝐜𝐡 𝐢𝐬 𝟐𝟓% 𝐦𝐨𝐫𝐞 𝐭𝐡𝐚𝐧 𝟒.𝟐𝟒% 𝐚𝐭 𝐭𝐡𝐞 𝐬𝐭𝐚𝐫𝐭 𝐨𝐟 𝐭𝐡𝐞 𝐲𝐞𝐚𝐫. This increase in risk premium implies that markets are not optimistic about equities and expect a premium of 5.29% over the ten-year treasury bond rates at 2.94%.

As of May 2022, markets expect an 𝟖.𝟑𝟑% 𝐫𝐞𝐭𝐮𝐫𝐧 (𝟐.𝟗𝟒%+𝟓.𝟐𝟗%) 𝐟𝐫𝐨𝐦 𝐭𝐡𝐞 𝐒&𝐏 𝟓𝟎𝟎 𝐢𝐧𝐝𝐞𝐱 (𝐛𝐞𝐭𝐚 𝐢𝐬 𝟏 𝐟𝐨𝐫 𝐭𝐡𝐞 𝐢𝐧𝐝𝐞𝐱), 𝟒𝟓% 𝐦𝐨𝐫𝐞 𝐭𝐡𝐚𝐧 𝟓.𝟕𝟓% 𝐢𝐧 𝐉𝐚𝐧𝐮𝐚𝐫𝐲 𝟐𝟎𝟐𝟐.

Now, we dont know the effect of corporate earnings on the higher interest rate. As of the last quarter, the corporate results were good. However, if the growth rates fail to meet the forecast and the fed continues to hike interest rates, the risk premium will increase.

Thus, in my view, 𝐢𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧 𝐜𝐨𝐮𝐥𝐝 𝐛𝐞 𝐭𝐫𝐚𝐧𝐬𝐢𝐞𝐧𝐭, and the recent hikes in fed rates would bring the inflation to normalcy, or inflation could be permanent, and the fed would continue to hike interest rates. In the latter case, the 𝐔𝐒 𝐞𝐜𝐨𝐧𝐨𝐦𝐲 𝐰𝐢𝐥𝐥 𝐬𝐥𝐨𝐰 𝐝𝐨𝐰𝐧 as companies cannot meet the earnings forecasts.