My previous post addressed the issue, "Is the stock market overgrazed?" It raised questions about the forward-looking expectations for the beta, size and value premiums that have existed historically. Researcher Claude Erb showed that each of these premiums has been declining over time, leading to at least the suspicion that they have been "overgrazed." *Erb noted that the one place that a declining premium had not been noted is in the case of small value stocks.
Erb specifically looked at the question of has the momentum premium been overgrazed in a paper, "Momentum Has Not Been 'Overgrazed': A Visual Overview in 10 Slides." Erb shows that while the large-cap momentum premium has declined from 12.5 percent to 7.5 percent a year, it's still well above the equity risk premium, which has declined from 8.5 percent to 4.3 percent. He also showed that the small cap momentum premium, while declining, is still above 10 percent.
Erb concluded that while familiarity and belief could lead to overconfidence, overinvestment and "overgrazing," explaining the seemingly poor trends for the equity risk premium, the size premium, and the value premium, relative to other equity market opportunities, "momentum" does not appear to be "overgrazed." The evidence would suggest that the continued high payoff to momentum is a result of "significant doubt and disbelief," allowing the momentum premium to persist. While "widespread investor acceptance of and belief in momentum could lead to overgrazing…" there is no sign of overgrazing yet.
*Erb used a three-step process to create the trend line.
Step 1: He linked the monthly excess returns into a "growth of $1" cumulative. The "market" excess return is monthly total return minus monthly Treasury-bill return from Ken French's website.
Step 2: On a monthly basis he calculated the 10-year annualized rate of return. The first calculation covered the 10 years from June 1926 to June 1936, the second from July 1926 to July 1936, etc. Part of the reason for using the 10-year time horizon was that is the time horizon Campbell and Shiller used in their early CAPE ratio research.
Step 3: He created a trend line using an excel/powerpoint function that regressed the rolling 10-year return on time (the x axis). So the 4.3 percent equity risk premium (the stock market total return in excess of the return of the t-bill) is the best fit of the relationship between 10-year excess return and time as of April 2014, or given the way that 10-year equity excess returns have evolved over time, the relationship that best captures the downtrend in this measure suggests that the trend equity risk premium is currently 4.3 percent.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.