Citigroup Inc (C), MetLife Inc (MET): What’s Up With The Equity Risk Premium?

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Stocks are cheap. No, really. They’re very, very cheap.

If you ask the right people, you’ll hear that stocks are cheap because the equity risk premium has skyrocketed. Just check out this nifty chart from the New York Federal Reserve Bank’s Liberty Street Economics blog.

Source: Liberty Street Economics.

“Now, back up a minute,” you may be saying. “What is this equity risk premium you speak of?”

I’m glad you asked. The equity risk premium measures the implied additional returns that investors get for investing in stocks as opposed to putting their money in an instrument that delivers the “risk-free rate” — often assumed to be U.S. Treasuries. If, for example, the S&P 500‘s price-to-earnings ratio (P/E) was 15 — and, therefore, the earnings yield was 6.7% — and the risk-free rate was 3%, then we could say that the equity risk premium was 3.7%. (That’s not the primary or only way to calculate the equity risk premium; I just used it for ease of illustration.)

When the equity risk premium is very low, stocks become less attractive because investors aren’t getting much additional returns for the additional risk they’re taking on by investing in stocks (remember, the alternative is “risk free”). On the other hand, when the equity risk premium is particularly high, it can be a fantastic time to invest in stocks because investors can expect a hefty helping of above-risk-free returns.

As the chart above shows, the folks at Liberty Street have concluded that we’re solidly in that latter situation right now:

The value of 5.4 percent for December 2012 is about as high as it’s ever been. The previous two peaks correspond to November 1974 and January 2009. Those were dicey times. … It is difficult to argue that we’re living in rosy times, but we are surely in better shape now than then.

Fair points about both 1974 and 2009. But dicey times or not, for both 1974 and 2009, stock market results over the next five to 10 years were pretty darn attractive.

And it’s not just the wonks at the Fed that care about this equity risk premium. When Appaloosa Management’s David Tepper went on CNBC earlier this week and got the whole market all hot and bothered, he waved around the above chart as part of his bullish thesis. And for those not familiar with Tepper, he’s no piker — Appaloosa manages around $18 billion.