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In the world of investing, significant market upheavals over the last five decades—such as the 1987 crash, the dot-com bubble, the Global Financial Crisis (GFC), and the COVID-19 downturn—have been characterised by a blend of initial enthusiasm followed by widespread fear. Each of these crises sparked discussions about whether traditional metrics like the price-to-earnings (P/E) ratio had become obsolete, often with a chorus of voices insisting “this time is different.”
However, history shows that peaks in major global indices often occur, confirming that equities were overvalued, albeit recognised only in hindsight. On the ascent, proponents of a so-called ‘revolutionary economic driving force’ often justify higher stock prices, while sceptics warn of impending disaster.
Recent surges in government bond yields have heightened scrutiny of the robust performance of US equities, particularly in light of the rapid advancements in Artificial Intelligence (AI). The divergence in opinion regarding whether the soaring stock prices of AI-related companies are warranted is palpable, with some asserting that current valuations are justified while others fear a painful correction.
P/E Ratio: A Limited Tool
The P/E ratio, calculated as the price of a stock divided by its earnings, remains a fundamental valuation metric. A P/E of 20x indicates an investor is paying $20 for a dollar in earnings. However, this figure only highlights the cost, without providing context regarding alternatives like government bonds. For instance, a P/E of 20 looks vastly different when bonds yield 1% versus 5%. A low yield on bonds makes stocks appear attractive, while a higher yield changes the investing calculus entirely.
To gain a clearer perspective, investors often turn to the equity risk premium (ERP). This framework assesses how much additional return investors expect from stocks above a risk-free rate, helping to evaluate the relative attractiveness of equities versus bonds.
Understanding the Equity Risk Premium
The ERP outlines the risk-reward profile of the stock market relative to government bonds. While government bonds are deemed "risk-free," owning stocks involves considerable risk, including the potential for earnings misses or company insolvencies.
To calculate the ERP, one considers the current market price of a major index, its earnings, projected future earnings growth, and the prevailing risk-free rate. The resulting figure indicates the return investors require to justify owning stocks at their current valuations.
Aswath Damodaran, a renowned finance professor, has detailed the ERP for the S&P 500 since 1960, providing invaluable context for analysis today. Currently, Damodaran’s model indicates an ERP of approximately 4.24%.
Current ERP Insights
The historical chart plotting Damodaran’s ERP showcases investor demand for risk compensation over time. A high ERP often corresponds to periods of investor fear or pessimism, while lower readings suggest confidence.
Historically, when the ERP dipped below 3%, as observed during the dot-com bubble, the S&P 500 subsequently experienced negative returns. On the other hand, peaks above 5% have historically indicated robust returns, particularly in the aftermath of the GFC.
With today’s ERP at around 4.24%, it suggests a middle ground—neither signalling a bubble nor indicating extreme undervaluation. Over the past 65 years, periods starting with an ERP in this range have produced moderate average returns, suggesting that current stock valuations do not reflect major discrepancies.
Implications for ASX Investors
The valuation of the S&P 500 is significant for Australian investors, as the ASX and US markets tend to correlate closely. Recently noted by Morgan Stanley, the ASX 200’s forward P/E ratio sits at the upper end of historical norms, hinting that the market is priced for expected earnings growth.
Morgan Stanley has identified potential downside risks—particularly in sectors such as banking and consumer goods—due to the tightening of monetary policy. Meanwhile, the resources sector is anticipated to drive most earnings growth.
Conclusion
Historical data indicates that starting with an ERP in today’s range has not led to negative average returns for the S&P 500 over five years. This challenges the pessimistic narratives fueled by rising bond yields.
However, being fairly valued does not imply cheapness. Expectations for future earnings growth must materialise, particularly in light of significant advancements in AI.
For investors on both sides of the Pacific, the crux remains: will the anticipated earnings growth justify current stock valuations? The ERP may not provide a definitive answer, but it serves as a reliable indicator of whether stocks are priced for perfection or positioned for a downturn. At present, it highlights reasonable growth expectations without asserting miraculous outcomes.
References
- Damodaran, A., Equity Risk Premiums (ERP): Determinants, Estimation and Implications, NYU Stern School of Business, March 2026.
- Damodaran, A., Implied ERP daily data, pages.stern.nyu.edu/~adamodar, updated May 1, 2026.
- Morgan Stanley Australia Limited, Australia Macro+ Mid-Year Outlook: A Whole New Set of Arrangements, May 18, 2026.
