The equity premium puzzle, under normal circumstances an academic curiosity for professional economists to debate in learned and obscure papers, is now confronting investors in US equities with its complexities and ambiguities. The stakes are high: Goldman Sachs sees the S&P 500 at 1,300 within 12 months; others see a double dip recession or outright depression with stock prices doomed to revisit the March 2009 lows. The investor who gets this call right will be amply rewarded.
The Conundrum – from Wikipedia:
The equity premium puzzle is a term coined in 1985 by economists Rajnish Mehra and Edward C. Prescott. It is based on the observation that in order to reconcile the much higher return on equity stock compared to government bonds in the United States, individuals must have implausibly high risk aversion according to standard economics models. Similar situations prevail in many other industrialized countries. The puzzle has led to an extensive research effort in both macroeconomics and finance. So far a range of useful theoretical tools and several plausible explanations have been presented, but a solution generally accepted by the economics profession remains elusive.
In addition to explanations of the puzzle, some deny that there is an equity premium at all; notably, following the stock market crashes of the late 2000s recession, there has been no global equity premium over the 30-year period 1979–2009, as observed by Bloomberg.
Current Manifestations – 10 year Treasuries currently yield less than 3%, while the yield implied by the TTM P/E on the S&P 500 is in the area of 7%. Using Goldman Sachs' operating earnings estimates for 2011 of 93, the implied yield for the S&P 500 now stands at 9%. Using Goldman's 1 year target of 1,300 for the S&P, the yield would be 25%.
For many years, US investors were safe in the belief that in the end stocks always go up, yielding 8% over any substantial period of time. The beatings administered by the tech bubble crash and the recent credit crisis have destroyed that line of thinking.
Residential real estate was similar – it might ebb and flow a bit, but in the end it would always go up. That belief has likewise been demolished.
Apparently, risk aversion has reached the point where no amount of projected forward earnings or optimism on the part of CEOs can reassure the fearful ones.
Alternatively, continued success in bear raiding global asset classes has emboldened speculators and manipulators to the point where they are concerned only with volatility – valuation be damned.
Profit Motivation vs. Risk Aversion – in a logical world, profit motivation would limit the premium imposed by risk aversion and the situation would become stable, with differentials easily explained by comparative volatility. Leaving the economists' equations out of it, and sticking with concepts I can understand, these two forces are not diametrically opposed, but sometime work in unison to depress prices for asset classes identified as risky. Here is the thought process:
Hedge fund managers and other risk tolerant investors have gravitated to an investing style that parks capital in safe haven assets such as but not limited to US treasuries. From that vantage point, they survey global asset classes incessantly, making regular concerted forays into so-called risk assets - directional bets in line with the prevailing market trends. This is the so-called risk trade, which has two states: on and off.
Vulture investors have become extraordinarily patient, since the unstable financial system will continue to deliver progressively riper carrion for their delectation until all possible victims have been taken down. Wilbur Ross and his peers continue their television appearances, peddling their visions of doom.
According to these lines of thinking, it doesn't matter whether stocks are cheap – if they are going down, there is no reason to buy until there is blood in the streets.
A Thought Experiment – I spent some time last night trying to replicate the thought process of an investor confronted with a choice between two asset classes – 10 year US treasuries and US equities. Rather than making one choice and staying with it, my assumption was that if the investor went with treasuries he would move over to equities if they went down enough. The hypothetical investor is an opportunist, waiting for blood in the streets.
The result is pretty simple: if investors think stock prices will go down 15% from where they are now, or that they are more likely to go down than up, then something like a 5% risk premium is in order. However, if a substantial decline is not in the cards, or if stocks are more likely to go up than down, then the risk premium evaporates and P/Es of 20 to 33 would be logical.
What drives this thing is greed and fear, as long as they both agree there another leg down, they both require a risk premium. That's why greedy people are so adept at whipping up fear. However, greedy people also suffer from fear, the debilitating dread of missing a profit opportunity.
Dynamic Tension – it should be noted that the above situation is unstable. Numerous pundits have observed that when a situation that cannot continue indefinitely goes on too long, the resultant corrections are severe in nature.
My personal experience bears this out. The insurance business, and particularly the commercial lines area of it, is unstable and cyclical. For years during the early 80's, companies competed with each other in lowering prices to attract additional business. It was not uncommon for prices to be reduced by 20% on an annual basis, even for large accounts with credible loss experience demonstrating that the prices granted were not economically feasible.
Of course the situation ended badly, around 1985. Prices for commercial insurance went through the roof and 40 or 50% renewal price increases became the norm. The whole thing was stressful and aggravating, although agents and brokers made a lot of money when prices went up the way they did.
Stock prices right now give me a similar feeling to what insurance prices did then. During the past earnings season, many stocks that I follow beat and raised, only to be rewarded with a sharp decrease in price. As the drumbeats of doom have intensified, they continue to tank. Meanwhile, CEOs as a group are optimistic if somewhat cautious about managing expectations.
Investment Implications – please consider the following:
As long as there is any sizable asset class on a global basis that is considered likely to decline substantially below its fair value, vultures and risk traders will take the same approach as risk averse investors – they will gravitate to perceived safe havens. However, at some point all the easily trashed financial entities will have been taken down and there will be no reason to wait for additional declines.
US treasuries cannot possibly continue as a safe haven for the simple fact that at some point inflation will cut in and interest rates will rise, pushing prices lower.
US equities cannot continue their current under-valuation, because in the aggregate these companies have far more cash than they need to support operations and more is accumulating as retained earnings. Share buybacks are proliferating, and soon enough financial engineering will again rear its lovely head, as borrowing money to buy back shares will suggest itself to lazy and greedy management. The excess cash will also be deployed in acquisitions, creating quick 40 or 50% pops for undervalued stocks.
My approach to this is to accumulate ownership or control of as many shares of viable US companies as possible with the capital I devote to my discretionary account. The only limitation is to manage my investments so as not to be subject to margin calls or any form of forced liquidation. We'll see how long this goes on.
Disclosure: Author is long US equities