Blog - Investing Notes

May 20, 2009 - Update: CFOs Project the Equity Risk Premium

How do the corporate experts most responsible for assessing the cost of equity currently feel about future stock returns? In their May 2009 paper entitled "The Equity Risk Premium amid a Global Financial Crisis", John Graham and Campbell Harvey provide an updated report on the views of U.S. Chief Financial Officers (CFOs) on the prospective U.S. equity risk premium relative to the 10-year U.S. Treasury note (T-note) yield, assuming a 10-year investment horizon. Based on 36 quarterly surveys on this topic over the period June 2000 through March 2009, they find that:

• CFOs on average currently expect an annualized raw return of 7.49% for the S&P 500 index over the coming decade. This expectation implies an equity risk premium of 4.74%, well above the overall series average of 3.46% and the highest value for the series.
• The standard deviation of individual responses in the most recent survey is 4.11%, the highest level of disagreement for the series.
• Associated personal interviews indicate that CFOs follow the stock market closely. They interpret the equity risk premium 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 equity risk premium relates:
• Weakly positively to the real interest rate.
• Strongly positively (correlation 0.68) to the implied volatility of the S&P 100 index option (VIX). (See the chart below.)
• Strongly positively (correlation 0.61) to the credit spread (Moody’s Baa rated bond yield less the T-note yield).
• Weakly negatively to prior-year stock returns.
• Non-linearly to the aggregate stock price-earning ratio.

The following chart, taken from the paper, shows the contemporaneous relationship between the survey-based prospective equity risk premium and the VIX across all 36 quarterly surveys. The correlation between the the two series is a notable 0.68. Both series appear to be rebounding from an extreme low in 2006.

In summary, a current survey of U.S. CFOs indicates a prospective U.S. equity risk premium that is on a three-year uptrend (to 4.74%, the highest in the series).

For other research on the equity risk premium, see Blog Synthesis: The Equity Risk Premium.