Equity Risk Premium Model

ERP Model (Updated on 7-31-2019).xlsx
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​Latest Update: July 31, 2019
Updated by: John Moschella
Model Summary: This model uses the Fed Funds rate, 10-year U.S. Treasury rate, implied volatility, equity market returns, and the Constant Sharpe Approach, to estimate the Equity Risk Premium (ERP). The ERP and the Capital Asset Pricing Model (CAPM) are used together to calculate the required return on equity for our DCF-based share valuation models.​

What Has Changed Since the Last Model Update: The latest FOMC meeting on July 30th/31st resulted in a 25 basis point decrease in the target Fed Funds rate. This is the first rate cut since 2008. The decision was in-line with expectations; However, the market reacted negatively to Chairman Powell’s explanation of the cut representing a “mid-cycle adjustment”. This was initially interpreted to mean that the July cut did not signal the start of a rate cutting cycle. Later in the press conference the Chairman explained that additional future cuts are possible, which stabilized the market, but left spectators someone confused. Ultimately, leaving the door open to future cuts without backing the FOMC into a situation where the market prices in a 100% probability of another cut, is probably a favorable position for the FOMC.
 
The market’s expectations for future interest rates remain nearly unchanged from our previous check in June. The CME Group’s FedWatch Tool, which estimates the market’s expectation of the Fed Funds rate using pricing of Fed Funds futures contracts, currently implies Fed Funds rates of 2.00% for September, 1.88% for October, and 1.80% for December. This compares to 1.95%, 1.87%, and 1.76% for September, October, and December respectively prior to the latest FOMC meeting. Overall the market continues to price in approximately 30 basis points of further rate cuts for the year. We will see how this estimate changes with the next round of economic data.

Summary of Forecast Approach and Latest Data Changes in the ERP Model: Each quarter the new interest rate, market return, and volatility results must be input into the Equity Risk Premium model. In addition, new estimates must be entered for each metric. This section clarifies the approach used to form the future expectations in the “base-case” version of the ERP model.
  • Volatility: We assume volatility will regress toward the long-term historic average. We take the difference between the current quarterly average VIX and the long-term average, and divided it by the remaining number of quarters contained within the model. We then add the incremental change in volatility each quarter to smooth the forecast back to the historic average. 
    • Latest Forecast for Volatility: As a result of the recent stabilization in volatility, the trailing one-year average VIX estimate used in the ERP model has decreased to 14.89% down from the previous 16.52%.
    • User Input: If you believe the market is headed for a period of uncertainty, you can change the blue input cells to increase the future volatility assumptions. If you believe the market will stabilize, you can decrease the volatility assumptions within the ERP model. 
  • Fed Funds Rate: In our base-case scenario we assume the Fed Funds rate will increase or decrease based on the market's expectations as approximated by the CME's FedWatch tool, which uses Fed Funds futures contracts to asses the probability of future rate changes. The market's expectations are periodically compared to the FOMC's latest Projection Material, to determine if the market outlook is dislocated from that of the FOMC members.
    • Latest Forecast for the Fed Funds Rate: Based on the month-end market expected Fed Funds rates Based on the CME estimates described in the section above, the forecasted average Fed Funds rate by quarter has been updated as follows: 3Q2019E 2.17%, 4Q2019E 1.89%, 1Q2020E 1.74%, and 2Q2020E 1.66%.
    • User Input: If you believe rates will be higher/lower in the future, then change the Fed Funds input cells.
  • Spread Between 10-year Treasury and Fed Funds Rate: We use 10-year futures contracts to determine the expected spread for the next quarter. Then smooth the spread towards the long-term average spread adjusting by 25 basis points per quarter, which reflects the fact that spreads can persist above or below the historic average for long periods of time. 
    • Latest Spread/RF Rate Forecast: The model risk-free rate, which is the average 10-year U.S. Treasury rate based on the Fed Funds forecast and spread projections is  now 1.99% up just 3 basis points from the previous 1.96%.
    • User Input: In general, if the market expects the economy to expand, the yield curve will steepen and the spread will increase. If the market expects the economy to contract the spread will decrease. If you believe we are headed for an expansion, then you may want to increase the spread assumption in the model. If you believe we are headed for a contraction, then you may want to decrease the spread assumption in the model.
  • Market Return/Sharpe Ratio Assumption: The average total return for the S&P500 through 1963 has been 11.4%. The market return assumptions in our base case scenario assume that the average annual return in the future will be approximately equal to the historic average.
    • Latest Forecast For Market Returns: The 2019 Constant Sharpe ratio based on the market return expectations and risk-free rate forecast is now 0.320, based on a total market return of 12.1%, slightly above the historic average.
    • User Input: If you believe market returns will be higher or lower in the future, then adjust the forecast returns in the model.
Resulting ERP Related Metrics: The latest estimates from the revised ERP model used for the DCF-based valuation in all of our Premium Models include the following:
  • Forecast for average market volatility: 14.89% (below the historic average, and current quarterly average).
  • Expected average risk-free rate of return: 1.99% (above the current 10-year U.S. Treasury rate of 1.88%).  
  • Resulting stage-one ERP estimate: 5.3%
  • Required return on equity assuming a beta of 1.0: 7.8%
​Disagree with this projection? We maintain "base-case" models for our community members to download and input their own forecast. There are many factors you can change in the ERP model including: the timing of Fed rate changes, the spread in the 10-year Treasury vs the Fed Funds rate, volatility assumptions, and equity market return projections. Try it today, and share your forecast with the Gutenberg Community. 
Planned ERP Model updates:​​​
  • September 17, 2019: FOMC meeting.Target Fed Funds rate update.
  • September 30, 2019: Quarterly data Maintenance (update equity returns, volatility, and interest rates).
  • October 29, 2019: FOMC meeting.   Target Fed Funds rate update. 
  • December 10, 2019: FOMC meeting.   Target Fed Funds rate update. 
  • December 31, 2019: Quarterly data Maintenance (update equity returns, volatility, and interest rates).
  • January 29, 2020: FOMC meeting.   Target Fed Funds rate update.

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