What's Happened to the Equity Risk Premium?

Jasper asks, in the comments:

Can you comment generally on how much less risky it is to invest in the stock market now than it was 3 months ago? In other words, now is obviously a better time to invest in stocks than it was 3 months ago, if you were going to invest in stocks anyway. But has the risk fundamentally changed, so that investors should dramatically shift allocations away from bonds and treasuries into stocks?

The short answer is no, don't go doing anything dramatic. Indeed, Calstrs is making a determined effort not to start moving money around right now, and that makes perfect sense: Moving money around is a form of trading the market, and trying to trade this market is a really good way of losing money.

What's more, a common-or-garden portfolio rebalancing strategy will, in and of itself, mean that you're probably going to move money from Treasuries (which have gone up) into stocks (which have gone down a lot, and therefore now account for a smaller part of your total portfolio). If you want to keep your asset allocation at where it was a year ago, you're already buying quite a lot of stocks right now, so you don't need to change your big-picture asset-allocation strategy in order to achieve that end.

But all that said, stocks do seem to be a better long-term bet today than they were three months or a year ago. I asked Brad DeLong, who's something of an expert on the equity risk premium, whether it goes up when stocks go down, and he replied:

Yes--it does. We're revising a paper for the Journal of Economic Perspectives now. it's supposed to come out in the winter, and all the numbers are changing...

Start with the Gordon equation for the market as a whole: P = D/(r-g), and turn it around
r = D/P + g.

D/P has just gone up, and the long-run g of dividends hasn't gone down by very much--so the expected rate of return r must have risen by a lot.

This doesn't mean that stocks are cheap, of course, or that they won't fall quite a long way from current levels. But if you're investing for the long term, you can probably sleep better investing now than if you invested back when they were obviously much more overvalued.

Comments

[dr.doolittle:]

right on, pangea. stocks are "cheap" in the sense that their price has collapsed. in other words, where's the "p" in the "e"? "winning" the war on terror has always meant profiteering for wall street, which has been done successfully. Sorry that the business is no good, though!

No one has any clue about whether the market is "expensive" or "cheap." Is there demand for the product, though and can it get financed? The 90's was all about one thing: what are your plans for expansion. I see no reason to change that ethos. If a business is executing on its expansion plans, that's a business worth buying in here, especially since it's not just the American people but the whole industrialized world that's gone off the deep end relative to their politics.

2008 Nov 08 02:15 PM

[von Murgenthal:]

Soo?
your bank pays you 3% interest !
Your local utility pays 7% dividend !

2008 Nov 08 07:46 PM

[Did U Think...:]

I am concerned that the Dow is only down to 8900 yet people are trying to act like a bottom has been put in.

Why do I say "only down" to 8900 given that the peak was 14k? Simple: that peak was a clear bubble. It was never real - not ever. Thus it should not be used as a relative metric of fair value. In fact, we never did finish unwinding the dot bomb bubble. In 1995, pre dot bomb, the Dow was 4k. then over a scant 5 year period it rose to touch 12k. 3x in 5 years is a little extreme. Strike that - it's a LOT extreme. In 1990 it was 2500 and so even the move to 4k in the next 5 years was quite good, but 3x in 5 years? No way. So now we gave some of that 14k peak back and the Dow is now up about 2x in a decade. Many people think that makes stocks cheap. But unemployment is skyrocketing and wages are starting to fall as a result. We are having a deflationary crash and very smart people like Mike Shedlock and Robert Prechter and others have been saying this would happen for many quarters now. So all of this was predictable, and these guys predict it will get a lot worse.

Pretty soon people will figure out that stocks cannot go up this high this fast. The stock market is not a wealth generation machine, it's a wealth redistribution scheme. It's gambling the same way a pyramid scheme is gambling and 1/3 of the participants are boomers who are by now scared to death that their retirement will evaporate, and rightfully so. Any gambler knows, once the gambling money is gone, it's gone. Thus, the boomers will continue to pull their money out of the ponzi scheme in any way they can. It also may not be much longer before money markets start to break the buck like Reserve Primary Fund did. Many would have followed already without the treasury bail outs, but will those last now that the elections are over? Why did Paulson say he wanted no part of the position of Treasurer once Obama came in? Clearly he knows that the bail outs must stop and when they do the markets will collapse.

Just think what the markets would look like today without all of the bail outs. Dow 1500? Less? What will happen when the bail outs do stop?

Think about it.

2008 Nov 09 02:07 AM