One of the best signals for when stocks are a great or poor deal is a metric called the Equity Risk Premium. It measures the market’s estimate of the future returns you can expect over the next decade from the S&P 500 versus what you’d garner from shouldering a lot less risk (and sleep far better) by holding 10-year Treasury notes. Put simply, the ERP’s a good proxy for the “margin of safety” that Warren Buffett says shareholders should cherish. Kenneth French, the distinguished financial economist at Dartmouth’s Tuck School of Business, described the ERP to this writer as “the holy grail of stock market investing.”
The ERP is simple to calculate. Start with the S&P 500’s earnings yield: the profits, over the past 12 months under standard GAAP accounting, that each $100 invested in the index is earning. Then subtract the “real” or inflation-adjusted yield on 10-year Treasuries, as measured by Treasury Inflation Protected Securities (TIPS). In other words, it’s the market’s best take on the annual return on stocks versus the anticipated number for super-safe government bonds.
