Thinking Long Term About the Equity Premium
Posted by Rob Weigand.
One of my favorite blogs, Abnormal Returns, recently linked to a post at the blog Zero Beta regarding the Equity Premium “Puzzle.” I’ve published a few papers on this topic recently (Journal of Portfolio Management, Journal of Investing and Journal of Financial Planning — forthcoming in October), so the literature remains fresh in my mind. Here’s the perspective I’ve cultivated after reading over 100 papers on the Equity Premium:
The only way to properly conceptualize risk premia is from a very long term perspective (as in Siegel’s Stocks for the Long Run). US equity markets have set the long term real return on equities at just under 7%. But egg-headed professors look back on the data — with the benefit of perfect hindsight — and say 7% was too large, AS IF EVERYONE KNEW STOCKS WOULD EARN 7% REAL RETURNS. Duh! The equity premium has been that large because people were extremely unsure how compelling global events would play out — at the time those events were occurring.
Try to appreciate the incredible uncertainty associated with two World Wars, the Great Depression and the Cold War. All of these events eventually worked out for the best — and thank goodness for that — but investors didn’t KNOW they would when those events were playing out. Moreover, the US economy was closer in time to regularly-recurring bank panics than we are today (I would assert that we currently suffer from a false sense of security that regulation and Fed monetary policy is better than it used to be).
As if in response to all this contrived thinking about the equity premium being too large historically, the equity premium is smaller today — any way you measure it. Yet, as we’ve seen with the subprime banking crisis, the world is just as uncertain as it used to be. Russia and the Middle East have most of the oil — and we’re no closer to independence from foreign oil than we were under Jimmy Carter. The Chinese have a work ethic that would make the average American faint — just THINKING about it. And we have witnessed a pronounced decline in the value of the US dollar in recent years (the recent rally notwithstanding). Residential real estate is in a protracted bear market and the credit creation system is gummed up beyond all recognition (GUBAR). We’re as up against it as we’ve ever been. And we may very well prevail, just as we always have — but we don’t know that with the type of perfect certainty that warrants real expected returns on stocks of 3-5% (or lower).
When you look at the P/E ratios (use 10-year smoothed earnings as suggested by Graham & Dodd, Shiller and others) and dividend yields on the major indexes, however, these metrics don’t reflect the expected returns necessary to fully compensate for the real risks going forward — at least as those risks appear to a rational person TODAY. (That’s why the super-rich are hoarding cash and cash equivalents and, as the Forbes crowd always loves to do, hoarding gold.)
One of the major factors holding up equity values in the current bear market (and keeping relative valuation high compared to this point in bear markets historically) are all the “jocks” that have migrated into professional money management. You know who they are — they’re lined up a mile deep to get their 5 minutes on CNBC and say things like “Stocks have always paid off and I’m really bullish on America,” or “Stocks look really cheap to me right now,” etc. Of course, they never back up their forecasts with any metrics — they just spout pro-market “feelings.”
Now, all this doesn’t mean that equity values can’t rise from current levels as soon as the news turns more positive than negative, but if they do, we’ll just be perpetuating the rolling global asset bubble that’s been hanging over markets since the latter 1990s (read Jeremy Grantham’s Barron’s interview on the global bubble and credit crisis from February, or his more recent post on the global competence meltdown). Therefore, after reading 100+ papers and publishing 3 myself, my perspective is that markets have set the LONG TERM equity premium just right historically, and this premium remains too low today when considered alongside the financial, economic and political risks that prevail in the current environment.
You can email Rob Weigand at profweigand@yahoo.com or find him on the web at Rob Weigand’s Home Page.
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Financial Market Commentary 
I think the last statement is very powerful, stating that the risk premium is too low with respect to the level of volatility in the market. The devaluation of the US Dollar, the energy crisis in America and banking troubles leave America in a profound predicament: Where do we turn next? The recovery from each recessionary period leads us to a newfound humilty, realizing that the market is cyclical. Following months of prosperity, however guide us into feelings of immortality. We feel that we are in complete control of the market. Any past mistakes in the market have been dealt with and learned from as to never repeat. This feeling is great until markets behave in an unexpected manner. This leads to volatility in our thoughts, simply as a result of human nature. Human nature leads us to question the very principles we believe: When things are going well, we feel in control; When times are struggling, we feel out of control. Just two months ago, within a matter of one week, two separate analysts predicted oil to be $160 per barrel and $83 per barrel. That is nearly a 100% difference! Unimaginable.
This leads me to my final agreement point on the blog. Over the long term and only in the long-term can we see sustainable returns. In the book “A Random Walk Down Wall Street,” Burton Malkiel points out that had investors been out of the stock market for the 90 best days of stock performance from the mid 1960s to the mid 1990s, investors would have realized no returns! Finally, the volatility in the market is shaped by many different factors at the moment and I agree that the risk premium is too low.
Dr. Weigand, does your conclusion that the equity premium presently is too low lead you to the further conclusion that potential new investors should stay in cash and stay out of the market or to the conclusion that new money should be invested in individual stocks that appear to provide a greater than average opportunity? If the latter, are you of the further opinion that in such an environment it is not advisable to invest in index funds – since they will simply return market performance, which you have concluded is too low?
Professor Haines, I must confess that I don’t have a very successful track record as a stock market forecaster. I’m a low-cost, long-term, buy-and-hold indexer myself — but I’ll do my best to address your insightful questions. My analysis about the equity premium would only be good for forecasting if the market operated on a mainly rational basis, at least most of the time. I am of the opinion, however, that Lord Keynes had it right when he said markets operate more on “animal spirits,” meaning emotion. That’s certainly what fueled the 2003-07 mini-bull market (which many now feel was a sustained bear market rally). No bull market ever started from average P/E ratios in the 30s. So the type of long-term equity premium thinking described in my blog post is valid only for VERY long horizons. For example, since 2000, the 10-year Treasury Note has delivered equal or better returns than the S&P 500. But you would have needed a will of steel to stay parked in Treasuries while others earned good returns in stocks in 2003 and 2004.
Going forward, I think stocks are priced to deliver better long-term returns than they were in 2000, but still at least 2% below their historical average of 7% real. For the long-term investor (horizons of 10 years and longer), I believe stocks will provide better protection against inflation than bonds — especially at today’s bond yields, which are way too low. Overall, investors should save more and use equity returns of 3.5-5.0% real in their financial plans, rather than the 6.5%-7.0% stocks used to deliver. I don’t think an investor can make it to the finish line holding too much cash over long horizons. But I would certainly understand if someone who was currently holding a lot of cash felt squeamish about allocating a lot to equities right now. I think they still have plenty of time to watch the market finish bottoming out and begin increasing their exposure to equities late this year or sometime in 2009. There is still a lot of risk out there, and I think we’re going to be getting some discouraging economic news in Q3 and Q4 2008.
Yes this is something to be measured in the long term but your emotions very much feel it in the short term.
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