S&P 500 10Yr Expected Equity Risk Premium



Calculating S&P 500 10Yr Expected Annualized Equity Risk Premium (ERP) over 10Year US Treasury Bonds
Four Key Premises: (1) The expected S&P 500 ERP over 10Year Treasury Bonds is more important and relevant to a longterm investor than the expected ERP over 3Month TBills. (2) Because earnings are so volatile and cyclical from year to year, PE10 is more important and relevant to longterm investors than PE1 or any PE based on expected earnings. (Definition of PE10 from Wikipedia: "The cyclically adjusted pricetoearnings ratio, commonly known as CAPE or Shiller P/E, is a valuation measure usually applied to broad equity markets. It is defined as price divided by the average of ten years of earnings (Moving average), adjusted for inflation.") (3)UPenn Professor Jeremy Siegel wrote:...the earnings of a firm is based on real assets whose value will, over time, increase with the rate of inflation. Therefore the earnings yield is a real yield. The historical data confirm this contention. In the United States, data of corporate profits go back to 1870 and the average PE ratio during that period [from 1870 to April 2007] has been 14.4, leading to an average earnings yield of 6.9%. This is onetenth percentage point above the average real return on equities, which is 6.8% over the period. [Source: ] (4) Real yield on 10year TIPS = Expected real yield on 10year treasury bonds = Expected annualized real return on 10year treasury bonds The Variables: (A) Expected annualized real return on the S&P 500 (including dividends) over the next 10 years = Expected yearly earnings yield on S&P 500 = Inverse of PE10 = 3.9% currently (source: ). (B) Real yield on 10year TIPS = Expected annualized real return on 10year treasury bonds = 0.6% currently (source: ). The Calculation: (A)  (B) = 3.3% = S&P 500 10Yr Expected Annualized ERP over 10Year Treasury Bonds. Historical Perspective: From 19282013 the annualized ERP for the S&P500 vs. 10year treasury bonds has been 4.62%, whereas from 19622013 the annualized ERP for the S&P500 vs. 10year treasury bonds was 3.33% (source: ). Best, Neil

