Market Valuation: Equities Remain Expensive

We use a residual income model to value the market[1]. The residual income model produces an estimate for the equity risk premium, or the additional return that equity investors are compensated over the risk-free rate. Fig. 1 shows how the equity risk premium has trended over time.

Since the COVID-induced equity market selloff in early 2020, the equity risk premium has trended between 3-4%; it spent most of 2022 in that range. However, during fall of last year, the equity risk premium decreased sharply. At the end of October, the equity risk premium reached a multi-year low of 2.65%. As of January 24, the equity risk premium sat at 2.85%, below the historical range.

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While the equity risk premium indicates the overall attitude of equity investors toward risk, it cannot, by itself, indicate the attractiveness of the equity market in a cross-asset framework.

We can compute an effective yield for the stock market by adding the equity risk premium to the risk-free rate....

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