Implied equity risk premium (ERP) hits lowest since 2008 as US stocks rally

Rising interest rates and higher stock multiples, typically decrease the Equity Risk Premium (ERP).

The S&P 500 has been on an upswing, climbing 3 percent in the past month. As the US market continues to climb, the implied equity risk premium (ERP) for the S&P 500 has dropped to 4.23 percent, its lowest value since 2008.

"The implied ERP for the S&P 500 drops to 4.23 percent, its lowest value since 2008. As a forward-looking price of risk, the ERP drives everything in markets," Professor Aswath Damodaran of New York University, an expert on valuation, said in a recent tweet on X.

Tweet on X by Aswath Damodaran:  Implied ERP drops to 4.23 percent, its lowest value since 2008

What is Equity risk premium (ERP)?

The equity risk premium is the reward to the investor for taking a higher level of risk and investing in equity rather than risk-free securities. The level of risk and ERPs are directly correlated. The higher the risk, the higher the gap between stock returns and the risk-free rate and thereby a higher premium.

According to Damodaran, "ERP is the ultimate market barometer, reflecting the battle between greed and fear that animates the market. More generally, its level is determined by macro forces, information disclosure and behavioural forces."

What drives ERPs lower?

Rising interest rates and elevated stock multiples, driven primarily by multiples expansion, usually reduce the ERP, making bonds comparatively more attractive than stocks.

Implication of Low ERPs

Lower ERPs generally make investing in stocks less compelling, whereas higher ERPs imply greater potential rewards. The higher the equity risk premium, the more you will earn from investing in stocks than you would via risk-free assets.

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