Tuesday, May 14, 1996
A Foolish Market Ratio?
By MF DowMan

As Fools we don't spend much time worrying about the overall stock market, or in trying to predict where interest rates are going or what the price of pork bellies will be next month. We're primarily stock pickers, wedded to the notion that there are good opportunities for gain in any stock market. And since the people who spend their professional lives trying to predict the economy and the market seem to be so poor at it, we're probably better off limiting our world to something manageable like searching for bargain stocks.

Yet there seems something almost Foolish in a ratio I saw discussed recently in Investor's Business Daily -- the Equity Risk Premium. The stock market is obviously only one investment vehicle among many (although we happen to think it's the only one that makes sense over the long haul), and it therefore competes for investment dollars with other vehicles, principally the bond market. How then, does one know if the stock market presents a better opportunity than bonds?

One such test is the Equity Risk Premium, a ratio that compares the expected return on stocks to that expected from bonds. To calculate the ERP, add the stock market's current dividend yield (about 2.3% right now) to the estimated profit growth (the figure in the article was 7.2%). Then subtract the current 30-year bond yield (a little below 7% right now). If the difference is greater than 1, the theory goes, stocks represent an attractive alternative to bonds. (Right now, the difference is roughly 2.5, a good sign for stocks supposedly.)

Apparently, many of the big stock market sell-offs have occurred when the Equity Risk Premium dropped below 1 (meaning the bond market represented a better return). So how can Fools use this ratio? Well, to be honest, as simple as the ratio sounds, it may even be too complicated to be of any use for us simple Fools. Does anyone see any problems with the Ratio? (OK, let's not see the same hands every time.)

Right ... you there in the motley cap! You wonder how one predicts what the profit growth for the market is? 'Zactly!! I wonder the same thing. Where does this magical 7.2% figure come from? Measuring the dividend yield is one thing; that's an objective calculation. But I'd be surprised to hear the estimated profit growth is anything other than a wild guess. Roll the dice; throw out a number.

Problem number two? Fools don't invest in "the market." In fact, we aim to double the market's return of 10%-11% a year by picking a handful of stocks. So for us blinkered Fools, looking only to equities, that bond yield would have to start pushing the 22% annual average offered by the Dow approach before we could be convinced that equities have some real competition. When was the last time the government paid investors 22% on anything?

Next time you're confronted with one of these attractive ratios for predicting the market, look past the surface, Fool. What looks logical, nay, even Foolish, is often a smoke screen for another gooroo's market prediction. Until the Wise start consistently whipping our beloved and simple Dow Approach, who needs them? Keep your belled-cap fastened tightly while the Wise blow in and out of the court's favor. You'll still be juggling those high-yield balls happily long after they're long forgotten.

Transmitted: 5/14/96