Aswath Damodaran on "Momentum versus Contrarian":
I am not much of a market timer but there is one number I do track on a consistent basis: the equity risk premium. I follow it for two reasons. First, it is a key input in estimating the cost of equity, when valuing individual companies. Second, it offers a window into the market mood, rising during market crises.
For the ERP to play this role, it has to be forward looking and dynamic. The conventional approach of looking at the past won't accomplish this. You can however use the current level of the index, with expected cashflows, to back out an expected return on stocks. (Think of it as an IRR for equities.)
A little history on this "implied ERP": it was between 3 and 3.5% through much of the 1960s, rose during the 1970s to peak at 6.5% in 1978 and embarked on a two decade decline to an astoundingly low 2% at the end of 1999 (the peak of the dot com boom). The dot com correction pushed it back to about 4% in 2002, where it stagnated until September 2008. The banking-induced crisis caused it to almost double by late November 2008. As the fear subsided, the premium dropped back to pre-crisis levels by January 2010.
For the ERP to play this role, it has to be forward looking and dynamic. The conventional approach of looking at the past won't accomplish this. You can however use the current level of the index, with expected cashflows, to back out an expected return on stocks. (Think of it as an IRR for equities.)
A little history on this "implied ERP": it was between 3 and 3.5% through much of the 1960s, rose during the 1970s to peak at 6.5% in 1978 and embarked on a two decade decline to an astoundingly low 2% at the end of 1999 (the peak of the dot com boom). The dot com correction pushed it back to about 4% in 2002, where it stagnated until September 2008. The banking-induced crisis caused it to almost double by late November 2008. As the fear subsided, the premium dropped back to pre-crisis levels by January 2010.
Aswath Damodaran
Now, to the present. The ERP started this year at 5.20% and gradually climbed to 5.92% at the start of August. Today (8/8/11) at 11.15 am, in the midst of market carnage, with the S&P 500 at 1166 and the 10-year T. Bond at 2.41%, the implied ERP stood at 6.62%.
So what? If you are a contrarian, you could view this as an opportunity: a return to past norms (4-5% ERP) would translate into a 30-40% jump in the index). If you are a momentum investor, you see the thundering herd and join in, selling short or buying puts. If you are a fence sitter, you are liquidating your stocks and holding cash, waiting for steady state (which may be a long time coming). My last post should provide enough clues as to where I stand but if you are in one of the other camps, I will not try to convert you. Different strokes for different folks!
So what? If you are a contrarian, you could view this as an opportunity: a return to past norms (4-5% ERP) would translate into a 30-40% jump in the index). If you are a momentum investor, you see the thundering herd and join in, selling short or buying puts. If you are a fence sitter, you are liquidating your stocks and holding cash, waiting for steady state (which may be a long time coming). My last post should provide enough clues as to where I stand but if you are in one of the other camps, I will not try to convert you. Different strokes for different folks!
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