CFOs Project the Equity Risk Premium

How do the corporate experts most responsible for assessing the cost of equity currently feel about future U.S stock market returns? In their March 2012 paper entitled “The Equity Risk Premium in 2012″, John Graham and Campbell Harvey update their report on the views of U.S. Chief Financial Officers (CFOs) and equivalent corporate officers on the prospective U.S. equity risk premium (ERP) relative to the 10-year U.S. Treasury note (T-note) yield, assuming a 10-year investment horizon. Based on 48 quarterly surveys over the period June 2000 through March 2012 (an average 347 responses per survey), they find that:

• CFOs on average currently expect an annualized raw return of 6.45% for the S&P 500 index over the coming decade. This expectation implies an ERP of 4.48%, close to the peak of 4.74% observed in February 2009.
• The standard deviation of individual responses in the most recent survey is 2.97%, a relatively high level of disagreement for the series, with worst (best) case projected annualized return 0.34% (11.0%).
• Associated personal interviews indicate that CFOs follow the stock market closely. They interpret ERP as the long-term return above the T-note yield of buying and holding equities, so their average estimate indicates a geometric rather than arithmetic mean return.
• Informal statistical analyses suggest that the survey-based prospective ERP relates:
  • Weakly negatively to prior-year stock returns.
  • Non-linearly to the aggregate stock market price-earnings ratio.
  • Weakly positively to the real interest rate.
  • Positively (correlation 0.52) to the implied volatility of the S&P 500 Index (VIX). (See the chart below.)
  • Positively (correlation 0.51) to the credit spread (Moody’s Baa rated bond yield less the T-note yield).

The following chart, taken from the paper, shows the contemporaneous relationship between the survey-based prospective ERP and the VIX across all 48 quarterly surveys. The correlation between the the two series is a significant 0.52, but the most recent data indicates notable divergence.

How should investors react to findings?

The following chart, constructed using data from the paper and contemporaneous daily levels of the S&P 500 Index and VIX, relates four series to future S&P 500 Index returns at horizons of 63 and 126 trading days (46 observations). Results suggest that the CFO raw return forecast may be somewhat contrarily informative about stock market returns over the next three and six months. However, any predictive power appears to derive from embedded assumptions about interest rates (T-note yield) and not from insight regarding ERP. 

In summary, a current survey of U.S. CFOs indicates a near series high prospective U.S. equity risk premium relative to T-note yield (but low raw return because the T-note yield is low) and a near series high level of uncertainty (disagreement). Results are probably not useful for survey-to-survey stock market timing.

Cautions regarding findings include:

• As noted in the paper, sample size is modest for correlation analysis.
• This sample size concern is elevated for the six-month future stock market returns, which uses overlapping measurement intervals.

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