The key number for stocks: The Equity Risk Premium (ERP)

If there is one number that captures what the market mood is right now and how investors feel about equities collectively, it is the equity risk premium (ERP), i.e. the additional return that investor are charging for buying equities instead of putting their money into treasuries. The equity risk premium reflects the tug-of-war between hope and fear that equity investors bring to the market, and will vary on a day-to-day basis. As investors become more risk averse, they will a higher equity risk premium, which should translate into lower stock prices.

Last week provided a laboratory to observe movements in both direction in the equity risk premium. We started Monday morning (9/15/2008) with the S&P 500 at 1250 and the equity risk premium at 4.54%, but here is what happened over the week:

9/15/2008 (End of day): S&P 500 = 1193 ; ERP = 4.75% ; Fear rules (Lehman down)

9/16/2008 (End of day): S&P 500 = 1214; ERP = 4.67% ; Recovery (Hope for AIG/)

9/17/2008 (End of day): S&P 500 = 1156 ; ERP = 4.90%; Sheer, unadulterated Panic... 

9/18/2008 (End of day): S&P 500 = 1207; ERP = 4.70%; The world did not end!!!!

9/19/2008 (End of day): S&P 500 = 1255; ERP = 4.52%: Euphoria!!!

Now, that was a week for the history books!!!!

If you are wondering how I came up with these numbers, I won't bore you with the details here but you can download a paper on the topic on my website at

http://www.damodaran.com

Check under research/papers! I would love to have your comments!