Tying up our two-part series on premiums, today we'll explore the equity premium.
Claude Erb has done a series of papers in which he examines the various premiums - size, value, momentum, and beta - and found that there's a demonstrable trend in each case of the premiums shrinking in terms of realized returns. His April 2014 paper, "The Incredible Shrinking Realized Equity Risk Premium," focused specifically on the equity risk premium.
To create a trend line Erb used a three-step process:
Step 1: He linked the monthly excess returns into a "growth of $1" cumulative. The "market" excess return is the monthly total return minus the 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 it is the same time horizon that 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). He found that a 4.3 percent equity risk premium (the stock market total return in excess of the return of the t-bill) was 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.
It's worth noting that Erb's 4.3 percent estimate is very similar to the current real expected return using Shiller's adjusted CAPE 10. The CAPE 10 is now at about 25.9. That produces an earnings yield of about 3.9 percent. However, we need to make an adjustment to arrive at the forecasted real return to stocks because the earnings figure from the CAPE 10 is on average a lag of 5 years. With real earnings growing about 1.5 percent a year, we need to multiply the 3.9 percent earnings yield by 1.075 percent (1.5 percent x 5 years). That produces a real expected return to stocks of about 4.2 percent.
Having estimated the equity risk premium at 4.3 percent, Erb noted that "the realized 'equity risk premium' has been in a downward trend since 1925. He explained that while a constant equity risk premium, and mean reversion, leads to the view that the probability rises over time that stocks will outperform high quality bonds, a declining equity risk premium, and mean reversion, leads to the view that the probability increases over time that safe assets will outperform stocks. He suggests that the declining equity risk premium has created a conundrum for many investors: Is it stocks for the long run, or bonds for the long run?
Erb also noted that a simple extrapolation of the declining trend in the equity risk premium results in a 0 premium by 2050. Logically (not that markets are always rational - see March 2000 when the earnings yield was below the yield on TIPS), that world shouldn't exist since no one would buy riskier stocks if there was no expectation of earning a risk premium. In other words, Stein's Law applies: If something cannot go on forever, it will stop (usually ending badly when it comes to stocks). However, it's certainly possible that instead of reverting to its historical mean (as many, such as Jeremy Grantham, are predicting) the equity risk premium could remain where it is, or even decline somewhat further. There are several possible/likely explanations for why the equity risk premium has been falling:
- When risk capital is scarce, it earns high "economic rents." As national wealth increases, the equity risk premium tends to fall as more capital is available to invest in risky assets. All else equal our rising national wealth should be expected to lead to a fall in the equity risk premium.
- Over time, the SEC's regulatory powers have increased, and accounting rules and regulations have been strengthened. The result is that investors have should have more confidence to invest in risky assets. Again, all else equal, this should lead to a smaller required equity risk premium.
- Implementation costs of equity strategies have fallen. Both commissions and bid/offer spreads have come way down over time. In addition, mutual fund expense ratios and loads are also much lower. And, the Internet has made trading much easier/more convenient. All else equal, lower implementation costs should lead to a lower equity risk premium. Lower trading costs can also help explain the falling small cap premium that Erb had found.
- Longer life expectancies can lead investors to have a stronger preference for equities as they provide the higher expected returns that may be needed to allow portfolios to last for longer horizons.
The bottom line is that while it's certainly possible that the equity risk premium could revert to its historical mean, mean reversion of valuations is far from a certainty. Thus, investors shouldn't draw the conclusion that the market is overvalued, nor that it's ripe for a fall.
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.