One of the most widely cited relative value market metrics is the Equity Risk Premium (ERP) which essentially is the $SPX earnings yield (inverse of P/E) less the10YR Treasury yield. At the October 4th low the ERP had reached one of the cheapest levels since the 2009 low and as far back as the 1974 low around 600bps. We believe this was a primary indication stocks were near a bottom as investors in heavy size were selling equity at near the cheapest valuation in history to buy bonds at near the most expensive valuations in history.
However as markets stabilize we think its important investors consider a stricter valuation metric in what we call the Real Equity Risk Premium which we measure by taking the earnings yield less the YOY gain in the CPI. With the Fed’s continued attempts to manipulate the long end of the yield curve and w QE 3 still on the table it can be a bit dangerous to rely on the basic ERP for market relative value despite what many on Wall St would have you believe. Even Bernanke thinks by lower nominal yields below the rate of inflation is positive for multiples but we think history shows valuation is more concerned with inflation and not interest rates.
We have charted both the ERP and Real ERP over each other and identified something very interesting. While the Earnings Yield would routinely trade through the 1oYR yield when stocks were outperforming it rarely ever traded through the CPI as can bee seen by previous valuation peaks in 2000 and 2008. In 2008 the flight to quality in the 10YR in the face of spiking inflation made equities look cheaper than they really were than if priced v CPI.
During the 2008 inflation spike one of the main culprits was oil and gasoline as prices at the pump surpassed $4/gal in spring of that year. You don’t need us to tell you about the recent spike in gas prices. Even if you don’t drive you see it on the news and hear it from the politicians. Gas prices have become one of the biggest Presidential Race issues.
We wanted to show this relationship between ERPs and include the CPI over gas prices to demonstrate how the market can get expensive when inflation spikes. Clearly gas prices have an effect on CPI and it obviously works with a lag. Our concern with market valuation is that when looking at the current $3.88/gal it is consistent with much higher CPI run rate, closer to 4% rather than the 2.9% Feb print. This would tighten the current 400bps Real ERP to closer to 300bps and with stocks rallying on mostly multiple expansion into rising inflation the Real ERP can contract quickly. We aren’t anywhere close to the zero line even at 4% YOY CPI but if gas prices takeout the $4 level the inflation pressure on the multiple should start to kick in and defense is warranted.