The Equity risk Premium has all but vanished

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Gordon
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The Equity risk Premium has all but vanished

Post by Gordon » Mon Mar 26, 2012 1:54 pm

In the March issue of the economist I read an article that stated that the equity risk premium has all but disappeared and that puts all pension plans in danger and investors such as indexers as well.


Investopedia explains 'Equity Risk Premium'
The reason behind this premium stems from the risk-return tradeoff, in which a higher rate of return is required to entice investors to take on riskier investments. The risk-free rate in the market is often quoted as the rate on longer-term government bonds, which are considered risk free because of the low chance that the government will default on its loans. On the other hand, an investment in stocks is far less guaranteed, as companies regularly suffer downturns or go out of business.

If the return on a stock is 15% and the risk-free rate over the same period is 7%, the equity-risk premium would be 8% for this stock over that period of time

perhaps our experts can comment on this? Where are you there Rick, Larry and William???

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Re: The Equity risk Premium has all but vanished

Post by FinanceFun » Mon Mar 26, 2012 1:58 pm

I'm up 12.9% this year. Heavy equities... 10y Tres is at 2.27%. Looks like a premium to me?

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Re: The Equity risk Premium has all but vanished

Post by Gordon » Mon Mar 26, 2012 2:03 pm

I understand that most insurance companies are close to bankruptcy and that they look for a three percent return on their securities and are not making that.

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Re: The Equity risk Premium has all but vanished

Post by hsv_climber » Mon Mar 26, 2012 2:16 pm

FinanceFun wrote:I'm up 12.9% this year. Heavy equities... 10y Tres is at 2.27%. Looks like a premium to me?


It is incorrect logic, since your 12.9% YTD has happened before March.
Someone needs to solve Gordon equation to calculate equity risk premium, which I am lazy to do right now.

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Re: The Equity risk Premium has all but vanished

Post by Rodc » Mon Mar 26, 2012 2:36 pm

Stocks are risky. Sometimes risk shows up. That is why it is risk.

When that happens over time period T, the measured equity risk premium for period T is low. Nothing new there.

Now what about the future? Do we believe the past predicts the future and if so in what direction? Do low returns past 10 years predicts low returns for next 10 years (and using induction, low returns forever?)? Or does return to the mean hold true and low returns past 10 years predicts high returns next 10 years? Or something else?
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

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Re: The Equity risk Premium has all but vanished

Post by yobria » Mon Mar 26, 2012 2:39 pm

Gordon wrote:In the March issue of the economist I read an article that stated that the equity risk premium has all but disappeared


During the recent bond boom + economic crash, the non-zero risk that bonds would outperform stocks did indeed show up. Does this mean investors have lost all rationality and will now demand a higher return from 3% yielding treasuries than a risky global stock portfolio? Not in my opinion.

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Re: The Equity risk Premium has all but vanished

Post by bobcat2 » Mon Mar 26, 2012 2:46 pm

Source: Credit Suisse Global Investment Returns Yearbook 2012

* the annual equity risk premium stocks vs. bonds for the 19 markets was 3.5% for the entire 112 year period from 1900-2011.
* the annual equity risk premium stocks vs. bonds for the 19 markets was 0.4% for the most recent 50 years from 1962-2011.
* the annual equity risk premium stocks vs. bonds for the 19 markets was -1.9% for the most recent 25 years from 1987-2011.

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Re: The Equity risk Premium has all but vanished

Post by FrogPrince » Mon Mar 26, 2012 3:02 pm

Can you say where this information is from? That is pretty serious if true.

Gordon wrote:I understand that most insurance companies are close to bankruptcy and that they look for a three percent return on their securities and are not making that.

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Re: The Equity risk Premium has all but vanished

Post by SimpleGift » Mon Mar 26, 2012 3:08 pm

Gordon wrote:In the March issue of the economist I read an article that stated that the equity risk premium has all but disappeared and that puts all pension plans in danger and investors such as indexers as well.

If we are talking about the same Economist article from March 2012, they point out that the equity risk premium has indeed been negative worldwide for the last decade — which is not at all an uncommon occurrence historically. Then they go on to suggest that their expectation of the future risk premium is about 4% real — right in line with the worldwide historical average over the long term. Most investors would welcome a 4% real equity premium on their investments going forward, I believe.
The Economist wrote:Although this figure is lower than the historical average, it still means that equity investors will earn a risk premium. The real yields on short- and long-term debt are zero, or negative in some cases. Nominal yields are close to historic lows. If the risk-free return is zero, then the entire return from equities will count as a risk premium. And a 4% premium would be only a little below the long-term average for America.

That still would not be high enough for many pension funds. In America, local-government pension funds base their contributions on the assumption that they will earn 8% (in nominal terms) on their investment portfolios. Treasury bonds yield 2% at the moment, so a 4% risk premium suggests a nominal return of 6% on equities. That means pension funds will fall well short of their targeted return.
Last edited by SimpleGift on Mon Mar 26, 2012 3:37 pm, edited 1 time in total.
Cordially, Todd

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Re: The Equity risk Premium has all but vanished

Post by yobria » Mon Mar 26, 2012 3:26 pm

bobcat2 wrote:Source: Credit Suisse Global Investment Returns Yearbook 2012

* the annual equity risk premium stocks vs. bonds for the 19 markets was 3.5% for the entire 112 year period from 1900-2011.
* the annual equity risk premium stocks vs. bonds for the 19 markets was 0.4% for the most recent 50 years from 1962-2011.
* the annual equity risk premium stocks vs. bonds for the 19 markets was -1.9% for the most recent 25 years from 1987-2011.

BobK


Hmm got a link? This paper shows an ERP vs bills of developed countries between 1950-2001 to be about 6%/year, graph page 13. And over the past 10, looking at Vanguard fund returns, the ERP's been slightly positive.

And these returns don't include the economic winners of the past few decades - emerging markets.

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Re: The Equity risk Premium has all but vanished

Post by SpecialK22 » Mon Mar 26, 2012 3:32 pm

I think the article was saying something similiar to what is echoed here: If you want a large enough nest egg to retire, you can't count on high returns from equities (i.e. you must save more). Certainly a concept worth repeating, but nothing jaw-dropping. What I did find particularly interesting in the article was the portion where it talked about the dividend yield:

The Economist wrote:The dividend yield comprised the vast bulk of the return. This was true across all the countries studied by the authors. Had investors consistently bought the highest-yielding quintile of equity markets over the last 112 years they would have earned an average nominal annual return of 13.3% compared with a return of just 5.4% for those buying the lowest-yielding quintile. High-dividend markets have also performed best so far this century.
.

Since dividend growth has been slow and well below GDP growth, the article argues that the ERP forward is likely to be lower than in the past but not non-existant.

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Re: The Equity risk Premium has all but vanished

Post by bobcat2 » Mon Mar 26, 2012 3:38 pm

Equity risk premiums for 19 markets over long periods of time - stocks vs. bonds

Source: Credit Suisse Global Investment Returns Yearbook 2012 -Page 57, Figure 2
Link:
https://www.credit-suisse.com/investment_banking/doc/cs_global_investment_returns_yearbook.pdf

These Yearbooks are annual updates to the data from 1900-2000 that were collected for the book, Triumph of the Optimists. They have also added three markets to the original 16 in the book.

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Re: The Equity risk Premium has all but vanished

Post by SimpleGift » Mon Mar 26, 2012 3:46 pm

The U.S. equity risk premium has been negative for 10-year holding periods before (see the 1970s in chart below, blue line). However, for 20- and 30-year holding periods, it's been more consistently positive. A good reason to invest for the long term and not get too excited about what happens over any 10-year period (positive or negative results).

Image
Data Source: Equity Risk Premiums - 2011 Edition
Cordially, Todd

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Re: The Equity risk Premium has all but vanished

Post by yobria » Mon Mar 26, 2012 3:49 pm

bobcat2 wrote:Equity risk premiums for 19 markets over long periods of time - stocks vs. bonds

Source: Credit Suisse Global Investment Returns Yearbook 2012 -Page 57, Figure 2
Link
https://www.credit-suisse.com/investment_banking/doc/cs_global_investment_returns_yearbook.pdf

These Yearbooks are annual updates to the data from 1900-2000 that were collected for the book, Triumph of the Optimists. They have also added three markets to the original 16 in the book.

BobK


Oh, I see, so your number above is comparing to long term bonds, which of course have their own set of risks and have had a fantastic run (but now nowhere to go). Against short term "bills", which is how the ERP is normally calculated in my experience, the figures from that paper were:

1962-2011=3.9%
1987-2011=5.2%

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Re: The Equity risk Premium has all but vanished

Post by bob90245 » Mon Mar 26, 2012 4:19 pm

Gordon wrote:Where are you there Rick, Larry and William???

You left out Jack Bogle. He seems to be expert on expected returns and when or when not to lighten up on equities.
Ignore the market noise. Keep to your rebalancing schedule whether that is semi-annual, annual or trigger bands.

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Re: The Equity risk Premium has all but vanished

Post by bobcat2 » Mon Mar 26, 2012 4:25 pm

Hi Yobria,
Quoting from the original post in this thread.
Gordon wrote:In the March issue of the economist I read an article that stated that the equity risk premium has all but disappeared and that puts all pension plans in danger and investors such as indexers as well.

Investopedia explains 'Equity Risk Premium'
The reason behind this premium stems from the risk-return tradeoff, in which a higher rate of return is required to entice investors to take on riskier investments. The risk-free rate in the market is often quoted as the rate on longer-term government bonds, which are considered risk free because of the low chance that the government will default on its loans. On the other hand, an investment in stocks is far less guaranteed, as companies regularly suffer downturns or go out of business.

If the return on a stock is 15% and the risk-free rate over the same period is 7%, the equity-risk premium would be 8% for this stock over that period of time

perhaps our experts can comment on this? Where are you there Rick, Larry and William???


Over the last 50 years the extra return on stocks vs government bonds has almost disappeared in the 19 markets since the premium has been only 0.4%. Perhaps it will be different in the future, but over the most recent five decades there has been for all practical purposes no risk premium in stocks vs government bonds.

BobK
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Re: The Equity risk Premium has all but vanished

Post by LH » Mon Mar 26, 2012 5:03 pm

If the premium has vanished, by all means leave stocks, go into bonds, if thats what you believe going forward.

Bonds outperform stocks sometimes.

Its hard to comment without reading the article, but its going forward that matters. That the equity premium has vanished going forward, would be a curious thing.

Also, the Gordon equation, is near useless for forward investing purposes.

Someone should have broke out the gordon equation in 2006 before the drop, in 1981 before the boom, etc...... It does not help. It is not predictive in an way that can be used.

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Re: The Equity risk Premium has all but vanished

Post by LH » Mon Mar 26, 2012 5:08 pm

yobria wrote:
bobcat2 wrote:Equity risk premiums for 19 markets over long periods of time - stocks vs. bonds

Source: Credit Suisse Global Investment Returns Yearbook 2012 -Page 57, Figure 2
Link
https://www.credit-suisse.com/investment_banking/doc/cs_global_investment_returns_yearbook.pdf

These Yearbooks are annual updates to the data from 1900-2000 that were collected for the book, Triumph of the Optimists. They have also added three markets to the original 16 in the book.

BobK


Oh, I see, so your number above is comparing to long term bonds, which of course have their own set of risks and have had a fantastic run (but now nowhere to go). Against short term "bills", which is how the ERP is normally calculated in my experience, the figures from that paper were:

1962-2011=3.9%
1987-2011=5.2%


So "bonds" = long term bonds eh? 60-70s to now, yeah they would do well. Heh, if the premiums vanished, go into long term bonds now, back up the truck : P

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Re: The Equity risk Premium has all but vanished

Post by SimpleGift » Mon Mar 26, 2012 5:24 pm

bobcat2 wrote:Over the last 50 years the extra return on stocks vs government bonds has almost disappeared in the 19 markets since the premium has been only 0.4%. Perhaps it will be different in the future, but over the most recent five decades there has been for all practical purposes no risk premium in stocks vs government bonds.

This claim seems very hard to believe. Dimson, Marsh and Stuanton's own publications indicate that the worldwide equity risk premium (over bonds) was 7.1% from 1950 to 2001, but only 5.5% for the previous 50 years. So there was a substantial rising trend in the second half of the twentieth century. See their paper (page 13): Global Evidence on the Equity Risk Premium.

Dimson, Marsh and Staunton wrote:A comparison between the first and second halves of our 102-year period makes the point. Over the first half of the twentieth century, the arithmetic average world equity risk premium relative to bills was 4.1 percent, whereas over the period 1950–2001, it was 7.7 percent. Figure 8 shows that most of the sixteen countries had lower mean premia in the first half-
century, with Australia, Italy, Belgium, and South Africa being the exceptions. The sixteen-country (unweighted) mean of the arithmetic risk premia in the first half of the twentieth century was 6.0 percent, versus 8.2 percent in the next fifty-two years. The pattern for the equity premium relative to bonds (not shown in Figure 8) is similar: a pre-1950 mean of 5.5 percent as compared to 7.1 percent over the following fifty-two years.


Image

These numbers would be lower if they included the last decade (2002-2011), but they'd be nowhere near zero.
Cordially, Todd

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Re: The Equity risk Premium has all but vanished

Post by beardsworth » Mon Mar 26, 2012 6:24 pm

John Hussman's latest regular Monday "Weekly Market Comment," accompanied as usual by a number of visual aids, discusses the nature of cyclical and secular bear/bull markets and current and historic equity risk premia.

http://hussman.net/wmc/wmc120326.htm

(Please, I would not want this post of mine to be the starting point for another one of this forum's many digressive flame exchanges about the Hussman Funds. I offer the link only because it represents one intelligent observer's commentary--for those interested in reading it--about the specific subject raised by the original post above.)

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Re: The Equity risk Premium has all but vanished

Post by stlutz » Mon Mar 26, 2012 7:21 pm

Oh, I see, so your number above is comparing to long term bonds, which of course have their own set of risks and have had a fantastic run


Since long-term bonds and stocks are both essentially asking you to tie up your money for a long period to time to get the expected return, the difference between the two shouldn't be that huge, so the Credit Suisse data makes some sense.

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Re: The Equity risk Premium has all but vanished

Post by bobcat2 » Mon Mar 26, 2012 7:26 pm

Hi Todd,

This claim seems very hard to believe. Dimson, Marsh and Stuanton's own publications indicate that the worldwide equity risk premium (over bonds) was 7.1% from 1950 to 2001


It's true the world ERP over bonds was about 7% over the 52 year period you cite. However, the large ERP from 1950-2001 got a huge boost from the decade of the 1950s. In the 1950s the 16 market ERP of stocks over bonds was 17.7%. So when comparing that 52 year period with the latest 50 year period we roughly keep 40 years of returns and replace a 12 year period when the ERP was was about 17% with a 10 year period where the ERP was -4.5%.

The data I have from Triumph of the Optimists shows the ERP for the 16 markets for the 41 years 1960-2000 was only 2.4%. So throwing out two good years at the beginning (60-61) and adding about -5% for the last 11 years will give you a small ERP over the last 50 years of about 1/2 of 1%. That is very much in line with the 0.4% they are reporting for the last 50 years.

Here is the 16 market ERP by decade from 1950-2000

Code: Select all

50s      17.7%
60s       4.9%
70s      -0.7%
80s       6.5%
90-00    -0.4%   (11 year period)

And from the latest report the last 10 years

02-11    -4.5%   - original 16 markets plus 3 additional small markets   


So the only year left out of the last 50 is 2001 and that was a very bad year for stocks.

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Re: The Equity risk Premium has all but vanished

Post by SimpleGift » Mon Mar 26, 2012 8:04 pm

Thanks, BobK. I pulled out an old version of Triumph of the Optimists and your data is indeed correct. The very low equity premium reported from the last 50 years just seems to be a quirk of the time period chosen, as it includes both of the negative premium decades of the 1970s and 2000s. If one expands the time period another ten years, then we're back to the 4% average annual equity premium.

Thanks for providing the actual numbers and your helpful explanation.
Last edited by SimpleGift on Mon Mar 26, 2012 8:19 pm, edited 1 time in total.
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Re: The Equity risk Premium has all but vanished

Post by grabiner » Mon Mar 26, 2012 8:17 pm

yobria wrote:Oh, I see, so your number above is comparing to long term bonds, which of course have their own set of risks and have had a fantastic run (but now nowhere to go). Against short term "bills", which is how the ERP is normally calculated in my experience, the figures from that paper were:

1962-2011=3.9%
1987-2011=5.2%


The reason that the Equity Risk Premium is calculated against Treasury bills is that it is the premium you were paid for taking a risk, and is thus computed against a risk-free investment. Long-term bonds have their own risk premium, which is why they usually yield more than short-term bonds (and when they don't, it is because investors expect rates to fall and long-term bonds to earn more than short-term bonds over their entire duration).
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Re: The Equity risk Premium has all but vanished

Post by bobcat2 » Mon Mar 26, 2012 8:21 pm

Hi Todd,

It seems to me the quirk in the data is the decade of the 1950s. The out performance of equities over bonds in the 50s is a complete outlier. None of the other 10 decades since 1900 shows an ERP close to half the size of the 17.7% ERP recorded in the 50s.

Global ERP Stocks vs Bonds

Code: Select all

1900-2011   3.5%   (entire 112 years)
1900-1949   3.8%   (first 50 years)
1962-2011   0.4%   (latest 50 years)
1950s      17.7%


The ERP for the 100 years that excludes the 12 year period 1950-61 is 2.1%. So 40% of the 112 year ERP of 3.5%, comes from the 12 year period 1950-1961.

BobK
Last edited by bobcat2 on Mon Mar 26, 2012 8:59 pm, edited 1 time in total.
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Re: The Equity risk Premium has all but vanished

Post by Rodc » Mon Mar 26, 2012 8:35 pm

grabiner wrote:
yobria wrote:Oh, I see, so your number above is comparing to long term bonds, which of course have their own set of risks and have had a fantastic run (but now nowhere to go). Against short term "bills", which is how the ERP is normally calculated in my experience, the figures from that paper were:

1962-2011=3.9%
1987-2011=5.2%


The reason that the Equity Risk Premium is calculated against Treasury bills is that it is the premium you were paid for taking a risk, and is thus computed against a risk-free investment. Long-term bonds have their own risk premium, which is why they usually yield more than short-term bonds (and when they don't, it is because investors expect rates to fall and long-term bonds to earn more than short-term bonds over their entire duration).


Agreed. I make no claim to be an expert but generally what I see is premium against risk free rate, not long term bonds.

One wonders is this is not another case of recency bias. Huge bull run in long term nominal bonds, so let's compare them to stocks.

Like the recent past articles headlined "Bonds beat stocks!" when what they really mean is "Very best bonds beat average stocks (briefly)". Not quite as catchy.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

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Re: The Equity risk Premium has all but vanished

Post by richard » Mon Mar 26, 2012 8:49 pm

There are two versions of the equity risk premium - backward looking and forward looking. For making investment decisions, all you should care about is forward looking.

Going forward, equities will likely have higher returns than bonds. This is a reward for being riskier than bonds. Without the hope of higher returns, why would anyone take on the greater risk?

Risk includes the possibility of lower returns, perhaps substantial and perhaps for extended periods. The fact that over some period bonds did better should not be a surprise, it's part of the reason it makes sense to hope equities will do better and therefore part of the reason to invest in equities..

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Re: The Equity risk Premium has all but vanished

Post by SimpleGift » Mon Mar 26, 2012 8:54 pm

bobcat2 wrote:It seems to me the quirk in the data is the decade of the 1950s. The out performance of equities over bonds in the 50s is a complete outlier. None of the other 10 decades since 1900 shows an ERP close to half the size of the 17.7% ERP recorded in the 50s.

Rodc wrote:One wonders is this is not another case of recency bias. Huge bull run in long term nominal bonds, so let's compare them to stocks.

Exactly right, Rodc. The unusual factor of the last 50 years is not that real equity returns have been at all below average. It's that real bond returns since 1980 have been so unusually strong (see chart below). This is what makes the equity premium against bonds (real stock returns - real bond returns) appear so meager for the last 50 years. Does anyone really expect high real bond returns going forward?

For reference, a chart of cumulative real returns for U.S. asset classes, 1900-2010 (from Dimson, Marsh and Staunton):

Image
Source: Equity Premia Around the World (Dimson, Marsh and Staunton)
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Re: The Equity risk Premium has all but vanished

Post by bobcat2 » Mon Mar 26, 2012 9:28 pm

Over the last 40+ years global bond returns have beaten global stock returns. That's because stock markets have performed relatively poorly over the last 40+ years, while global bond markets have had strong performance over much of the last 40+ years. That doesn't mean much going forward. Personally I would expect global stocks to outperform global bonds over the next 40 years by 2-4%. But given that we only have global market data for 112 years, that 40+ years of recent under performance would indicate that stocks are quite capable of under performing bonds over extended time periods. It's quite possible that the current global under performance of stocks could extend to a period of about 50 years before stocks once again out perform bonds.

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Re: The Equity risk Premium has all but vanished

Post by CaliJim » Mon Mar 26, 2012 9:31 pm

Gordon wrote:I understand that most insurance companies are close to bankruptcy and that they look for a three percent return on their securities and are not making that.


This is alarming. Source and links please.
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Re: The Equity risk Premium has all but vanished

Post by Nathan Drake » Mon Mar 26, 2012 9:31 pm

Where is the data coming from that the past 40 years have been better for bonds than stocks? I don't believe it.

I'm pretty sure US stocks at least have a 9% annualized return over that period. Outside of only select, and brief, points in time when US treasuries had very high yields (early 80s), I was under the impression that stocks had much better returns than bonds.

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Re: The Equity risk Premium has all but vanished

Post by SheebaElwood » Mon Mar 26, 2012 9:35 pm

How is there no equity risk premium?
The market is up almost 100% in the last 2 years.

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Re: The Equity risk Premium has all but vanished

Post by bobcat2 » Mon Mar 26, 2012 9:50 pm

Hi Nathan,

The real return on global equities over the last 40 years is lower than the US return on equities. Remember global stock returns include Japan. :(

Here is one quick & dirty way to see that global bond returns have beaten global stock returns over the last 40 years.

Over the last 50 years the global ERP is 0.4%
1960-69 global ERP was 4.1%

Where does that leave the last 40 years?

BobK
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Re: The Equity risk Premium has all but vanished

Post by Clearly_Irrational » Tue Mar 27, 2012 5:18 pm

Generally a fundamental model of future stock market returns is going to look something like this:

http://www.financialphysics.net/images/intro/figure9s.jpg

This predicts an after inflation return of around 5.5% which matches pretty closely what we've seen during the US fiat money period (1972-Present).

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Re: The Equity risk Premium has all but vanished

Post by yobria » Tue Mar 27, 2012 6:02 pm

Clearly_Irrational wrote:Generally a fundamental model of future stock market returns is going to look something like this:

http://www.financialphysics.net/images/intro/figure9s.jpg

This predicts an after inflation return of around 5.5% which matches pretty closely what we've seen during the US fiat money period (1972-Present).


Yes, those numbers are exactly what I use. And I'd expect an ERP of about 6% or so going forward, including emerging market (the figures above do not).

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Re: The Equity risk Premium has all but vanished

Post by gwrvmd » Tue Mar 27, 2012 7:19 pm

In some of the above posts the terms equity premium and equity risk premium are used interchangeably; theres a big difference
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SpecialK22
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Re: The Equity risk Premium has all but vanished

Post by SpecialK22 » Wed Mar 28, 2012 12:01 am

gwrvmd wrote:In some of the above posts the terms equity premium and equity risk premium are used interchangeably; theres a big difference


Care to explain the difference? I always thought the two terms were interchangeable.

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Re: The Equity risk Premium has all but vanished

Post by SimpleGift » Wed Mar 28, 2012 12:09 am

gwrvmd wrote:In some of the above posts the terms equity premium and equity risk premium are used interchangeably; theres a big difference

OK, I'll bite also, as they appear to be used interchangeably in the financial literature. A definition from Investopedia:

Investopedia wrote:Definition of 'Equity Risk Premium'
The excess return that an individual stock or the overall stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of the equity market. The size of the premium will vary as the risk in a particular stock, or in the stock market as a whole, changes; high-risk investments are compensated with a higher premium. Also referred to as "equity premium".
Cordially, Todd

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Re: The Equity risk Premium has all but vanished

Post by ilmartello » Thu Mar 29, 2012 1:02 pm

This seems to be an interesting thread. Much of the developed world, had high inflation rates in the late 70's to early 1980's A strong decline in interest rates over the last 30 or so years has helped give bonds an excellent return.

The current 10 yr treasury yields 2.15 percent. The SP 500 is yielding 2 percent. I am not a market timer, but I don't find it plausible that you could argue that over the next 10 years, The SP 500 price returns will be 0 and there will be no equity premium.

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Re: The Equity risk Premium has all but vanished

Post by Bill Bernstein » Thu Mar 29, 2012 1:55 pm

Hi All:

I see even the venerable Economist has fallen into the trap of looking only at the backward-looking ERP.

That's a rabbit hole, since at most times, you can come up with any backward-looking result you want. 2 years? Boffo. 10 years? Awful. More than 20 years? Not so bad. 100 Years? Perhaps more reliable, as long as you account for survivorship bias and changes in multiples.

As richard and yobria point out, it only makes sense to consider the forward-looking ERP. The good news, as others in the thread have pointed out, is that it's strongly positive. The bad news is that's only because the risk-free rate is so awful.

Bill

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Re: The Equity risk Premium has all but vanished

Post by SimpleGift » Thu Mar 29, 2012 4:35 pm

Dr. Bernstein, thanks for posting — and for your forward-looking perspective.

In a WSJ article from January this year, I recall you were projecting long-term annual stock returns of about 6.5% nominal (quoted below). If the current nominal yield of the 10-year Treasury bond, at 2.18%, portends its future return, then the expected equity risk premium (over bonds) would be a little over 4% going forward. Sound about right?

Though, with current, artificially-repressed Treasuries yields, the outcome might not be quite as rosy as expected.

Wall Street Journal on 1/28/12 wrote:With the S&P 500's dividend yield at 2% and the long-term growth rate of dividends and earnings at 4.5% (including inflation), a sensible expectation for long-term annual stock returns is roughly 6.5%, says William Bernstein, an investment manager at Efficient Frontier Advisors in Eastford, Conn.
Last edited by SimpleGift on Thu Mar 29, 2012 4:49 pm, edited 1 time in total.
Cordially, Todd

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Re: The Equity risk Premium has all but vanished

Post by Bill Bernstein » Thu Mar 29, 2012 4:47 pm

If you define the ERP that way, you're right.

I actually like to think in terms of the real expected ERP, not nominal, since it simplifies long-term personal planning calculations, and also because folks find it easier to agree on the real long-term earnings/dividend growth rate (estimates cluster very tightly around 1.5%) than nominal ones, which tack on the implied uncertainty of estimating inflation.

The question is what "risk-free" return to use. I prefer short T-bills, others like long TIPS. But there's no commonly agreed-upon rate. (My unscientific impression is that Chicago-types tend towards the 30-day bill, while folks who think about long-term liabilities, like pensions and retirement planning, like TIPS.)

So whenever you use the words "expected equity risk premium" you have to add "over ________."

Bill

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Re: The Equity risk Premium has all but vanished

Post by gwrvmd » Thu Mar 29, 2012 5:43 pm

I have had some doubts about my post 2 days ago that said equity premium and equity risk premium are different. Singlegift is right, apparently they mean the same.
But that bring up another de?bate: I think the term ERP is being used incorrectly.
Most people on the thread agree with the defination then say it is decreased, vanishing, dissappeared etc. The Economist says it "has all but disappeared".
I think it is increasing not decreasing, vanishing, or "all but disappeared"
To quote Mario Gabelli in the 2011 year end report of his closed end mutual fund The Gabelli Equity Trust:
"Valuations are attractive. The S&P is priced at 12 times earnings and offers a current yield of 2.1%. The last time stocks sold at 12 times earnings was 1991, a year when 10 year Treasuries were priced to yield 8% , as compared to 2% today. You can now find companies with sustainable dividend yields well above the 10 year U.S. Treasury note. Aside from a brief spell during the late 2008 meltdown, the market has not yielded more than the 10 year U.S. Treasury since the 1950s. This means that the equity risk premium, or the difference between the risk free bond yield and the earnings yield on stocks (the opposite of the price to earnings ratio) has been in record territory of late, at around 6%. This provides investors with a margin of safety as we head into 2012".
I believe Mario uses the term correctly, the ERP is going up not down, "in record territory of late, at around 6%" to use his words.
As a high percentage stock mutual fund investor, the higher the Equity Risk Premium goes, the better I like it.
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Re: The Equity risk Premium has all but vanished

Post by Rodc » Thu Mar 29, 2012 8:02 pm

wbern wrote:If you define the ERP that way, you're right.

I actually like to think in terms of the real expected ERP, not nominal, since it simplifies long-term personal planning calculations, and also because folks find it easier to agree on the real long-term earnings/dividend growth rate (estimates cluster very tightly around 1.5%) than nominal ones, which tack on the implied uncertainty of estimating inflation.

The question is what "risk-free" return to use. I prefer short T-bills, others like long TIPS. But there's no commonly agreed-upon rate. (My unscientific impression is that Chicago-types tend towards the 30-day bill, while folks who think about long-term liabilities, like pensions and retirement planning, like TIPS.)

So whenever you use the words "expected equity risk premium" you have to add "over ________."

Bill



But Bill, it is so much easier to get a good long thread going it no one defines terms. :)

Seriously, much disagreement comes from not defining terms and not using language precisely. So, I agree with you.
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Re: The Equity risk Premium has all but vanished

Post by yobria » Thu Mar 29, 2012 8:19 pm

Keep in mind the Vanguard corporate bond fund is (SEC) yielding 5.53% at present. And investors must demand a higher return from (much riskier by any measure) corporate equity than corporat debt.

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Re: The Equity risk Premium has all but vanished

Post by baw703916 » Fri Mar 30, 2012 10:27 pm

Why wouldn't shorter term TIPS constitute the risk free rate? TIPS of any duration do have a defined real return if held to maturity, but that can be a long time should you need the money sooner, and you certainly can have a paper loss in the short term.

Currently for 5-year TIPS, the rate of real return is -1.26%.

Ergo, even if stocks give zero over the next five years, there's still an equity premium.

Brad
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Re: The Equity risk Premium has all but vanished

Post by Lumpr » Sat Mar 31, 2012 12:30 am

baw703916 wrote:Why wouldn't shorter term TIPS constitute the risk free rate? TIPS of any duration do have a defined real return if held to maturity, but that can be a long time should you need the money sooner, and you certainly can have a paper loss in the short term.

Currently for 5-year TIPS, the rate of real return is -1.26%.

Ergo, even if stocks give zero over the next five years, there's still an equity premium.

Brad


I think the general arguement against TIPS as the risk free rate is that liquidity in TIPS is nowhere near bill/bond liquidity. As a result, the theory goes that some of the TIPS return includes a liquidity premium.

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Re: The Equity risk Premium has all but vanished

Post by baw703916 » Sat Mar 31, 2012 12:09 pm

Lumpr wrote:
baw703916 wrote:Why wouldn't shorter term TIPS constitute the risk free rate? TIPS of any duration do have a defined real return if held to maturity, but that can be a long time should you need the money sooner, and you certainly can have a paper loss in the short term.

Currently for 5-year TIPS, the rate of real return is -1.26%.

Ergo, even if stocks give zero over the next five years, there's still an equity premium.

Brad


I think the general arguement against TIPS as the risk free rate is that liquidity in TIPS is nowhere near bill/bond liquidity. As a result, the theory goes that some of the TIPS return includes a liquidity premium.


Which would mean that the risk-free rate is even less than -1.26% real (maybe -1.5% or so). That makes it even easier for there to be an equity "premium" even if you're just treading water by owning them.

Doesn't that also argue against long TIPS as the risk-free rate marker (as wbern suggests)? For the record, I own long TIPS, and don't really care about the liquity risk, so I'm happy to collect the premium.
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Re: The Equity risk Premium has all but vanished

Post by Rodc » Sat Mar 31, 2012 7:25 pm

baw703916 wrote:Why wouldn't shorter term TIPS constitute the risk free rate? TIPS of any duration do have a defined real return if held to maturity, but that can be a long time should you need the money sooner, and you certainly can have a paper loss in the short term.

Currently for 5-year TIPS, the rate of real return is -1.26%.

Ergo, even if stocks give zero over the next five years, there's still an equity premium.

Brad


Some people do use short TIPS and while anything has pros and cons, I think a decent argument can be made for short TIPS.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

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