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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.