Thus, if risk free rates move to 3% and the equity risk premium drops to 5%, the index is undervalued by about 5%, but if rates rise to 4% and the equity risk premium stays at 5.5%, the index is overvalued by 8.28%. There is another interesting aspect to the table that bears emphasizing. In fact, that is the reason that you have the large divergence in the market between those who use normalized PE ratios and argue that the boutique s are massively overpriced and those who use the equity risk premium or the Fed model today to make the opposite case. In 1981, the ERP was 5.73%, but it was on top of a ten-year US treasury bond rate of 13.98%, yielding an expected return for stocks of 19.71%. On May 1, 2013, the ERP is at 5.70% but it rests on a US treasury bond rate of 1.65%, resulting in an expected return on 7.35%. An investor betting on ERP declining in 1979 had two forces working in his favor: that the ERP would revert back to historic averages and that the US treasury bond rate would also decline towards past norms An investor in 2013 is faced with the reality that the US treasury bond rate does not have much room to get lower and, if mean reversion holds, has plenty of room to move up, and if history holds, it will take the ERP up with it.
While the details are still fuzzy and the initial bond issue may be for only about $10 billion, it seems likely that the debt issued will grow beyond that amount. The scary part is that there are no obvious safe havens: gold and silver have had a good run but don’t seem like a bargain and central banks around the world seem to be following the Fed’s script of low interest rates. Earnings have been abysmal and the coronavirus has already pushed companies from J.Crew Group Inc. to Neiman Marcus Group Inc. and Diamond Offshore Drilling Inc. into bankruptcy. DryShips, Inc. (DRYS) – DRYS is showing some strength in the $7’s. Drys needs to hold $5.00 on a closing basis which is the next major support level. “A lot of people were caught on the wrong side of market volatility, and the majority of flows we saw were essentially closing positions,” he said on a recent conference call. While this only had a limited impact, investors are likely concerned that the full lock-up expiration, which happens this March, will put a lot more pressure on the stock.