Where do we come up with the idea that stocks “should” provide returns substantially greater than bonds?
What are the factors that determine the expected future return of stocks as compared to bonds?
The answers to these questions are at the core of studies into the equity risk premium (ERP) and the CFA Institute has recently published a book of essays written by ERP thought leaders titled, “Rethinking The Equity Risk Premium”. This book is available in digital format (Adobe PDF) at no cost (or for $0.99 at the Amazon e-bookstore if you want a copy for your e-reader). The content is dense–this book is 164 pages long. The list of contributors to the volume is impressive and the writing is outstanding, which makes the book a rare “must read” for investment advisors and policy makers.
The book is the result of a meeting between a number of well-known experts in the theory and practice of money management. This meeting is the follow-up to a similar gathering that was held ten years ago. The last ten years have provided considerable food for thought with regard to the rationality of markets, volatility, financial crises, and pension policy. The authors present their outlooks for the future returns of stocks vs. bonds, as well as discussing the key factors that inform their thinking.
The Economist has a nice discussion of this book in the March 17th issue.
Some key issues that are explored:
1) Does it make sense to look at the historical risk premium as the basis for future expectations?
2) Is the equity risk premium a function of the current state of the economy?
3) How does the P/E of the market impact the expected risk premium?
4) Is the equity risk premium meaningfully predictable?
5) Can we ignore dividends in favor of total return?
Rather than try to summarize the book, I would like to offer a series of key thoughts and observations by the various chapter authors and hope that these excerpts will inspire readers to dig deeper into this centrally important concept. Let’s start with Roger Ibbotson’s introduction to the concept of the equity risk premium.
Roger Ibbotson (page 24):
“What is the equity risk premium? I consider it a long-run equilibrium concept that gives an estimate of the future excess return of the stock market over and above the bond market. There are several advantages to thinking of the ERP as an equilibrium concept. It provides the market’s estimate of the excess return on stocks relative to bonds. It is neutral in the sense that it does not take advantage of any particular investor’s expertise but, rather, tries to determine what the market thinks. In this way, it can be used as a benchmark for more active or dynamic forecasts of the stock market. It can also be used for long-term planning purposes in setting a long-term asset allocation or in estimating the returns that a portfolio can provide to meet various future obligations.”
Cliff Asness (page 30):
“I will forecast only the real (consumer price index–adjusted) return on the S&P 500, not the risk premium versus bonds…To do so, I like to start with the Shiller P/E, which was roughly 23.5 in early April 2011. I then reduce that number by 10 percent to get a measure of the current P/E using trend earnings (because earnings grow over time, the unmodified Shiller P/E is a lagging indicator of valuation). Doing so drops the Shiller P/E to about 21.5, which makes the earnings yield about 4.7 percent. To get a sustainable dividend yield, I cut the earnings yield figure in half to about 2.3 percent. Reducing the earnings yield reflects a historically reasonable payout ratio of about 50 percent, not the current payout ratio, which is lower….Next, I add about 1.5 percent for expected real growth in earnings. Using the Gordon growth model (Dividend/Price + Growth), the result is a long-term forecast real equity return of 3.8 percent.”
Dimson, Marsh, and Staunton:
“Many people argue that the historical equity premium is a reasonable guide to what to expect in the future. Their reasoning is that over the long run, investors should expect good luck to balance out bad luck. If this view is correct, then the average premium investors receive should be close to the premium they required and “priced in” before the event. But even over a period as long as 111 years, this expectation may fail to be the case. It is possible that investors have enjoyed more than their share of good luck, making the past too good to last. If so, the historical premium would reflect “the triumph of the optimists” and would overstate expectations.”
“In our article “The Worldwide Equity Premium: A Smaller Puzzle” (Dimson, Marsh, and Staunton 2008), we show that the equity premium can be decomposed into five components: the annualized mean dividend yield, plus the annualized growth rate of real dividends, plus the annualized expansion over time of the price/dividend ratio, plus the annualized change in the real exchange rate, minus the real risk-free rate.”
“Of these components, the dividend yield has been the dominant factor historically. At first sight, this may seem surprising because on a daily basis, investors’ interest tends to focus mainly on the capital gains element of returns, such as stock price fluctuations and market movements. Indeed, over a single year, equities are so volatile that most of an investor’s performance is attributable to capital gains or losses. Dividend income adds a relatively modest amount to each year’s gain or loss. But although year-to-year performance is driven by capital appreciation, long-run returns are heavily influenced by reinvested dividends.”
Rob Arnott (page 102):
“Bond yields are accepted as the dominant factor in setting bond return expectations, but dividend yields (and, often, even earnings yields) are seen as secondary to growth in setting equity return expectations. Yet, overwhelming global evidence suggests a strong positive link between the dividend yield and both the subsequent real return for stocks and the subsequent excess return of stocks over bonds. It is a myth that in an efficient market investors will accept a lower yield whenever they are confident that future real growth in earnings will make up the difference. It is a myth that in an efficient market investors will not care about payout ratios because retained earnings make up for the deferred income in the form of more rapid growth; that is, lower dividends now mean higher ones later.”
“Returns are, for the most part, a function of simple arithmetic. For almost any investment, the total return consists of yield, growth, and multiple expansion or yield change. For bonds, the growth is simple: Fixed income implies zero growth. For high-yield or emerging market debt, growth is negative because of the occasional defaults. For stocks, based on a long history, growth tends to be around 1 percentage point above inflation.”
Antti Ilmanen (page 107):
“The recent roller-coaster experiences in markets, as well as theoretical and empirical lessons, have converted many observers to the belief that expected returns and premiums vary over time. If so, then past average returns are a highly misleading indicator of future returns. Forward-looking valuation indicators are better and may provide useful timing signals. Low dividend yields or low earnings yields (or their inverse, high price-to-earnings ratios) are now seen as a sign of low prospective stock market returns in just the same way that low bond yields and narrow yield spreads are interpreted as a forecast of low returns in fixed-income markets. This forward-looking logic would have guided investors well during the low equity market yields of 2000 and high market yields of early 2009.”
Peng Chen (page 134):
“For the long-term investor, asset allocation is the primary determinant of the variability of returns. Of all the decisions investors make, therefore, the asset allocation decision is the most important.”
“The most important asset allocation decision is the allocation between stocks and bonds. Thus, the expected return between stocks and bonds, or the equity risk premium, is the most important number.”
Jeremy Siegel (page 150):
Of course, the 2007–09 recession dispelled the idea that the business cycle had been tamed. It is my opinion that the Great Moderation was indeed real, but the long period of macroeconomic stability led to an excessive decline in risk premiums, particularly in housing-related securities. So, when real estate prices unexpectedly fell, the entire financial system came crashing down. The financial crisis greatly increased the risk aversion of investors, and that result brought the P/E back down to historical levels and led to the poor stock returns of the past decade.
This outstanding book demonstrates the range of approaches to estimating the future equity risk premium and, consequently, the extremely diverse estimates of the future returns of stocks vs. bonds. As Dr. Peng Chen notes, there is hardly an issue that is of more central importance to investors, investment advisors, and policy makers.
The limitation of this important volume is not in the range of conclusions by the many authors, but rather in the lack of guidance as to how to use equity risk premium estimates. Let’s imagine, for example, that we come up with an estimate that U.S. stocks will generate 7.5% in arithmetic average annual return, with annualized volatility of 20%. The missing step is how to translate such an expression of the equity risk premium into the choice of an asset allocation. How does this equity risk premium drive the expected returns and volatilities of emerging market stocks or small cap stocks, for example? There are, in fact, consistent ways to see how a change in the ERP impacts total portfolio risk and return and I will take this theme up in a future article.
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