Equity Risk Premiums: An Update

As many of you are probably aware, I am fixated on equity risk premiums. To me they are at the center of almost every debate about equity markets - whether stocks are too low or too high, whether current market conditions are the norm or an aberration, and whether equity investors truly understand the risk associated with investing in equities.

I had a few posts during the crisis, where I noted that the implied equity risk premium for the S&P 500 had climbed at a rate never seen before in history during the twelve weeks between September 12, 2008 and late November. In fact, I reported an implied equity risk premium of 6.43% at the start of 2009, up from 4.37% at the start of 2008. The big debate at that point was whether this crisis had damaged investor psyches so much that it had caused a permanent upward shift in risk premiums, or whether this was just another bump in the road and that we would revert back to the 4% implied equity risk premiums, pre-crisis.

I have just posted an updated version of my equity risk premium paper online:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1492717
In the paper, I graph out the implied equity risk premium from January 2009 to September 30, 2009. On September 30, 2009, the implied equity risk premium stood at 4.86%. While I had anticipated at the start of the year that the premium would drift back down, I expected it to take much longer than 9 months. One more reason for constantly updating equity risk premiums! Markets are full of surprises.

The new debate that is unfolding is whether markets have gone up too far and too fast, thus exposing themselves to a correction. I don't know the answer to that question but it can be framed around the implied equity risk premium. If you think that the crisis should have changed people's attitudes about risk and that a 6% equity risk premium is the new steady state, markets are over bought and the correction will be painful (a 15%-20% drop in the S&P 500). On the other hand, if your view is that what happened last year is just part and parcel of equity risk and that investors will soon forget the scars and go back to the 4% risk premiums of 2007 and 2008, the bull market has a lot of steam left on it (a 10% up movement in the S&P 500). I am not giving away too much when I say that the long term equity risk premium that I am using for mature markets, when valuing companies, has been 5-6% since January 2009. At its current level of 4.86%, I am within reaching distance, but I will respond to the market on this number. I am not a market timer!